Can your organization beat hyper-inflation

without eroding shareholders value?

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What is Inflation?

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Inflation means too much money chasing very

few goods

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What is Hyper-Inflation?

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Hyper-Inflation is a situation where the price increases are so out of control that the concept of inflation becomes meaningless

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How can you beat sustainable hyper inflation?

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Do you think you can defeat hyper-inflation without eroding shareholder value just by passing additional cost to customer

or

Increasing earnings @ hyper-inflation

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If you think yes then please continue with this presentation your perception will change forever

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In the mid seventies & eighties there was huge inflation in US, approx.10%, lot of companies increase their earnings @ inflation but could not avoid eroding shareholders value

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Why Inflation makes harder to create value?

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Hyper-Inflation puts huge pressure on cost of capital in real terms and leads to losses in net asset positions that are fixed in nominal terms

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How do you beat hyper-inflation?

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You can’t beat it just by passing cost & increasing earnings @ inflation.

What’s the other way?

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Think…..

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Did you get any answer?

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No… ok go ahead to see the answer……

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You have to increase king of business @ hyper-inflation

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Yes you got it right!!!!!

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Increase cash flow @ hyper-inflation

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Increase in cash flow will lead to increase in ROIC, MARGINS & EARNINGS however sales volume are maintain at pre-level

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We are going to see it with an example by considering 3 scenariosScenario 1- Inflation @ 0%, margins, earnings & sales volume are maintain at pre-level

Scenario 2- Inflation @ 15%, earning increases @ inflation however margin & sales volume are maintain at pre-level

Scenario 3- Inflation @ 15%, cash-flow increases @ inflation which leads to increase in ROIC, MARGIN & EARNINGS however sales volume are maintain at pre-level

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Assumptions:

Company Sales - $ 1000 a year from year 1 to 17

Pre- Inflation Cost of Capital - 8%

Inflation - Constant 15% from year 2 onwards

Post- Inflation Cost of Capital - (1+ 8%) * (1+15%) - 1 = 24%

Capital Expenditure - Annual Capital Expenditure increases by 15% from year 2 onwards

Assets acquired at the end of the year & depreciated for the first time in the next year.

Assumed that assets life is 15 year

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Scenario 1

NPV ( Free Cash Flow) @ 8% = $ 985

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Sales 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000

EBITDA 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225

Depreciation 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125

EBIT 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

Gross PPE 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875 1875

Cumulative Dep. 875 875 875 875 875 875 875 875 875 875 875 875 875 875 875 875 875

Invested Capital 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000

EBDITA 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225 225

Capital Exp. 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125 125

Free Cash Flow 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

EBITA Growth % 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

EBITA Sales % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%

ROIC % 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%

Free Cash Flow Growth 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

* Sales Volume remains constant

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Scenario 2

NPV @ 24% = $495

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Sales 1000 1150 1323 1521 1749 2011 2313 2660 3059 3518 4046 4652 5350 6153 7076 8137 9358 10761 12375 14232

EBITDA 225 240 259 281 308 341 379 425 479 542 615 701 802 918 1053 1210 1392 1601 1841 2117

Depreciation 125 125 126 129 133 140 148 159 173 190 211 236 267 303 346 397 456 524 603 693

EBIT 100 115 132 152 175 201 231 266 306 352 405 465 535 615 708 814 936 1076 1238 1423

Gross PPE 1875 1894 1934 1999 2093 2219 2383 2591 2848 3163 3544 4000 4544 5188 5948 6840 7884 9105 10526 12180

Cumulative Dep. 875 875 876 880 888 903 926 960 1008 1072 1158 1270 1411 1589 1810 2082 2413 2812 3290 3858

Invested Capital 1000 1019 1058 1119 1204 1316 1457 1631 1841 2091 2385 2731 3133 3599 4138 4758 5472 6293 7237 8322

EBDITA 225 240 259 281 308 341 379 425 479 542 615 701 802 918 1053 1210 1392 1601 1841 2117

Capital Exp. 125 144 165 190 219 251 289 333 382 440 506 582 669 769 884 1017 1170 1345 1547 1779

Free Cash Flow 100 96 93 91 90 89 90 92 96 102 110 120 133 149 169 193 222 255 294 338

EBITA Growth % 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

EBITA Sales % 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%

ROIC % 10.00% 11.50% 12.98% 14.38% 15.63% 16.70% 17.57% 18.25% 18.76% 19.11% 19.35% 19.50% 19.59% 19.64% 19.66% 19.67% 19.67% 19.67% 19.67% 19.67%

Free Cash Flow Growth -3.75% -3.18% -2.44% -1.50% -0.35% 0.99% 2.52% 4.18% 5.91% 7.64% 9.30% 10.83% 12.18% 13.32% 14.26% 15.00% 15.00% 15.00% 15.00%

Earning increases @ inflation (15%), ROIC grows from 10% in year 1 to 19.67% in year 17 after 15 years of sustainable inflation however cash flow remains -ve in the first 5 years and afterward it grows +ve’ly and catches the inflation rate in year 17. After 17th year organization achieves a steady state. Due to hyper-inflation shareholders value gets destroyed as NPV(Free Cash Flow) reduces from $985 to $ 495

* Sales Volume remains constant

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Scenario 3

NPV @ 24% = $995

Increase in Cash Flow @ 15% inflation results NPV(Free Cash Flow) $ 995 that is equal to pre-inflation level of NPV and protects shareholders value. However increase in cash flow @ inflation requires EARNINGS to grow for more than 33% from year 1 which gradually decreases and achieves steady state of 15% growth in year 17 and same is true for MARGINS also which increases from 10% in year 1 to more than 17% in year 17 before achieving steady state. Organization needs to increase ROIC from 10% in year 1 to more than 34% in the year 17, after 15 years of inflation.

* Sales Volume remains constant

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Sales 1000 1150 1323 1521 1749 2011 2313 2660 3059 3518 4046 4652 5350 6153 7076 8137 9358 10761 12375 14232

EBITDA 225 259 298 342 394 453 520 599 688 792 910 1047 1204 1384 1592 1831 2105 2421 2784 3202

Depreciation 125 125 126 129 133 140 148 159 173 190 211 236 267 303 346 397 456 524 603 693

EBIT 100 134 171 213 260 313 372 440 516 602 699 811 937 1081 1246 1434 1649 1897 2181 2509

Gross PPE 1875 1894 1934 1999 2093 2219 2383 2591 2848 3163 3544 4000 4544 5188 5948 6840 7884 9105 10526 12180

Cumulative Dep. 875 875 876 880 888 903 926 960 1008 1072 1158 1270 1411 1589 1810 2082 2413 2812 3290 3858

Invested Capital 1000 1019 1058 1119 1204 1316 1457 1631 1841 2091 2385 2731 3133 3599 4138 4758 5472 6293 7237 8322

EBDITA 225 259 298 342 394 453 520 599 688 792 910 1047 1204 1384 1592 1831 2105 2421 2784 3202

Capital Exp. 125 144 165 190 219 251 289 333 382 440 506 582 669 769 884 1017 1170 1345 1547 1779

Free Cash Flow 100 115 132 152 175 201 231 266 306 352 405 465 535 615 708 814 936 1076 1238 1423

EBITA Growth % 33.75% 28.08% 24.49% 22.03% 20.28% 18.99% 18.02% 17.27% 16.70% 16.25% 15.89% 15.62% 15.40% 15.23% 15.10% 15.00% 15.00% 15.00% 15.00%

EBITA Sales % 10.00% 11.63% 12.95% 14.02% 14.88% 15.56% 16.10% 16.53% 16.85% 17.10% 17.29% 17.42% 17.52% 17.58% 17.61% 17.63% 17.63% 17.63% 17.63% 17.63%

ROIC % 10.00% 13.38% 16.82% 20.16% 23.26% 25.99% 28.30% 30.16% 31.61% 32.69% 33.45% 33.98% 34.32% 34.52% 34.63% 34.67% 34.67% 34.67% 34.67% 34.67%

Free Cash Flow Growth 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

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All the 3 scenarios suggests that in order to beat hyper-inflation organization needs to increase ROIC drastically which is normally very difficult to achieve during hyper-inflation. During US’s hyper-inflation in 1970-80’ organizations achieve ROIC between 8-12% however it was far less than required limit of 25-30% as suggested in scenario 3.

Lower cash flow and high cost of capital are the main evil in eroding share prices, and it happened during US’s 1970-80’ hyper-inflationary period

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Thank You

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For more information please contact:

Deepak Agrawald.agrawal2006@gmail.comhttp://www.deepakagrawalblog.wordpress.com/http://in.linkedin.com/in/deepakagrawal2009