Robert Bushman Complex Deals

1. Class 11: The Case of AluarAluminioArgentino S.A. Robert Bushman Complex Deals • Importance of having accurate price indices • Analyzing a company’s ability to cope with high inflation • A comprehensive illustration of preparing “constant currency” adjusted financial statements • Adjusting current and prior year’s balance sheets to their equivalence in current year-end purchasing power of the currency • Compute inflation adjusted income for the current year (and prior years) • Isolate the inflation exposure of net monetary items and compute inflation driven gains or losses. • Use adjusted statements to quantitatively assess how sensitive company is to inflation

2. Financial reporting & Inflation Illusion • Four deep inflation issues: • Nominal growth can mask decreases in purchasing power • Inventory holding gains distort reported profitability • Inflation and PP&E: Maintaining productive capacity • Monetary assets & liabilities => inflation related gains & losses

3. Inflation Indices in Argentina Price Index Official CPI as reported by INDEC (InstitutoNacional de Estadística y Censos) CPI computed by PriceStats(The PriceStats inflation series is a daily measure of inflation derived from prices posted to public websites by hundreds of online retailers)

4. Inflation Indices in Argentina Why is it important to know what the correct CPI is? % Inflation Rate Official CPI as reported by INDEC (InstitutoNacional de Estadística y Censos) CPI computed by PriceStats(The PriceStats inflation series is a daily measure of inflation derived from prices posted to public websites by hundreds of online retailers)

5. May 15, 2013, Argentina’s Inflation Dilemma The Argentine government has gone to extraordinary lengths, involving fines and threats of prosecution, to stop independent economists from publishing accurate inflation numbers. “Argentina’s courts, in a welcome moment of sanity, have overruled attempts by Argentina’s government to prevent anyone who isn’t the government from publishing a figure for inflation that isn’t what the government says it is.” Argentine farmers hoard soybeans as inflation hedge Fri, Sep 27 2013 BUENOS AIRES (Reuters) – Argentine farmers are hoarding more soy this season than in past years, threatening to reduce much-needed export tax revenue as raw beans become the preferred unit of savings in an economy impaired by double-digit inflation.

6. Inflation and Wages (April 2012) • Wage inflation has become a huge problem for businesses in Argentina. Argentina is a highly unionized country, and the unions have contracts with annual wage increases tied to the inflation rate (many based on private source figures, not the government inflation index). • Further, many non-union businesses peg their wage increases to those of the unions. This has resulted in wages in Argentina doubling in the last three or four years in many cases. • For example, one software company reports that it gave employees 25% annual raises in 2010 and 30% annual raises in 2011, and that was just enough to keep them competitive in the industry. • Company’s that do not have the flexibility to increase wages fast enough to keep up with inflation are losing their best performers to companies that can pay

7. Coping with inflation • Three operating capabilities to cope successfully with inflation. Ability to • Maintain productive capacity • Recall inventory holding gains and rising replacement costs for productive capacity from last lecture • During periods of high inflation rates shortages of key production inputs are often disrupteddue to hoarding • Improve productivity • To deal with rising inputs costs such as labor • Raise prices. • Some desirable characteristics: • Ability to pass inflation risk onto others • Control over critical input resources and distribution systems. • Ability to raise prices

8. How is Aluar situated to cope with inflation?

9. How is Aluar situated to cope with inflation? Aluar represents 1% of world aluminum production. Exports 70% of production into US$ denominated world market. Aluarhas a long-term US$ supply contract for raw materials from Alcoa.

10. How is Aluar situated to cope with inflation? Aluar represents 1% of world aluminum productions. Exports 70% of production into US$ denominated world market. Company's dollar denominated aluminum export price is a favorable protection against inflation to the extent the relative inflation rates in the USA and Argentina are reflected in the AR$/US$ exchange rate. The greater the inflation differential in favor of the US$, the more AR$ will receive for each US$. (AR$/US$ will increase with inflation (currency weakens!). But no control over output prices. Aluar's has a long-term supply contract for raw materials from Alcoa. • Guaranteed access to critical raw material. • However, favorable exchange rate advantage of selling into US$ denominated world market is mitigated somewhat by the reverse effect of paying for alumina in US$.

11. How is Aluar situated to cope with inflation? • Own their power generating capacity => guaranteed access to key production input • Prices of products sold in Argentina may not keep up with inflation • Argentina government may imposeprice controls on domestic product sales But, lets see what the inflation-adjusted financial statements tell us!

12. Inflation adjusting to assess sensitivity to inflation • The main work involves: • PP&E: Adjusting PP&E to 2010 purchasing power; inflation adjusted depreciation • Computing inflation adjusted COGS

13. Historical cost, constant-currency and current value accounting Aluar will be a combination of these two cells

14. Historical cost, constant-currency and current value accounting • Assume that a piece of land was purchased for investment in 1984 for $10,000. • At the end of 2014 ,the land has a market value of $100,000. • The effect of inflation over the 30 years from 1984 to 2014 has diluted the purchasing power of the dollar such that it takes $4.30 in 2014 to commandthe same purchasing power as $1.00 in 1984. We will see both of these in the Aluar case

15. Fiscal year ends on June 30

16. Monetary Assets & Liabilities • 2009 amounts must be adjusted to their equivalence in 2010 year-end purchasing power of the currency. • 2010 amounts are real and so already reflect 2010 purchasing power • Note that monetary liabilities are larger than monetary assets => • Aluar has a “net liability” exposure and we should expect an inflation related gain as the net liability is devalued by inflation

17. Inventories • Aluar accounts for inventory using replacement cost at the balance sheet date. • Don’t get hung up on this. All this means is that inventory “holding” gains are already dealt with (I’ll show you!) • We will however have to adjust the 2009 replacement cost inventory balance to its equivalence in 2010 year-end purchasing power of the currency. • Also some issues with COGS

18. PP&E • The issue is that PP&E at 6/30/2010 and 2009 contains items that were bought at different times over the last 8 years. • In order to get the carrying values and depreciation expense to be restated in terms of current purchasing terms we must deal with these timing aspects. • I will overview the structure of the calculations

19. Nominal PP&E, CAPEX and Depreciation Expense

20. Nominal PP&E, CAPEX and Depreciation Expense Nominal Balance Sheet

21. Nominal PP&E, CAPEX and Depreciation Expense Capex purchased mid-year (12/31) • The objective is to reflect 2009 and 2010 PP&E amounts in terms of 2010 purchasing power • PP&E was purchased at many different time periods over the years • Each item of PP&E is stated in terms of nominal currency from the time of purchase • Must restate nominal amounts from the time of each purchase into 2010 purchasing power terms

22. Adjust from 2003 nominal AR$ to yr end 2004 purchasing power @1.086 Adjust Capex to yr end 2004 purchasing power using WPI change from 12/31/03 - 6/30/04  122,724,486 * 1.039 1 2 1+2

23. Convert ending PP&E balance from 2004 AR$ to 2005 AR$ 1 2 1+2

24. Convert to 6/30/05 AR$ 1 2 1+2

25. 1 2 1+2 Adjust to next yr’s purchasing power

26. A B Adjust to 6/30/2004 purchasing power power B/A (5) + (7) Inflation adjusted PP&E * (6)

27. Inflation-adjusted Balance Sheet 6/2009 purchasing power 6/2010 purchasing power Monetary assets @ replacement cost Monetary assets Adjusted per previous slides Monetary liabilities + change in contributed capital excluding Net Income = 1,384,890,126

28. Changes in Owners’ Equity other than Net Income

29. Inflation-adjusted Balance Sheet Plug NI to make A=L+OE

30. Need To Compute Inflation Adjusted COGS

31. Need To Compute Inflation Adjusted COGS Direct & indirect costs absorbed into inventory Replacement cost adjustment These are stated at “replacement cost”

32. Calculation of Inflation-adjusted Cost of Goods Sold Inflation rate from 6/2009 – 6/2010 Computed in previous slides Purchases & Prod. Exp. assumed to be incurred smoothly over the year => Adjust using WPI change from 12/31/09 - 6/30/10 (from mid-year to year end) Inflation adjusted COGS

33. Inflation-adjusted Income Statement 2010 Gain on net monetary liability position- plug to get Net Income Plug number computed in balance sheet construction

34. 2010 Inflation adjusted Difference in large part due to restated depreciation

35. 2010 Inflation adjusted Difference in large part due to restated depreciation 240,451/710,100.7  34% 260,305/360,106  72% !

36. Moving from INDEC to PriceStats Inflation Estimates Period INDEC WPI PriceStats 617.80 678.96 714.71 786.18 890.05 New Indices

37. Moving from INDEC to PriceStats Inflation Estimates INDEC PriceStats