J.P Morgan & Company was advised by Brasil Investimentos to give a statement regarding a sale or restructuring of its subsidiary Paginas Amarelas – the telephone directory business. The responsibility for the valuation of business of Paginas Amarelas was given to Juan Lopez, a new associate of JP Morgan’s Latin America M&A Group who had better understanding of the business markets where they were conducting their businesses.. Juan Lopez estimated the future cash flow (in US$ as requested by the client) of the operations in the three Latin American countries (Argentina, Brazil and Chile) where they were competing. 

     After calculating the future cash flow, Lopez estimated the weighted average cost of capital (WACC) to find out the target rate of return for each country operation through which he determined the DCF value of the three country operation as well. 

     JP Morgan Company was basically a global financial service provider and considered as a major global player in the investment – banking industry. JP Morgan generally made use of three approaches-DCF (Discounted Cash Flow) method, trading multiples and transaction multiples for estimating the valuation of the company. 

     The Argentine subsidiary achieved 33 percent of Paginas Amarelas total net revenue whereas Brazil and Chile accounted for 52 and 15 percent of total revenue respectively.  In these three countries the telephone companies were state-owned and in monopoly position. The privatization of state-owned companies ended the operation of monopoly marketers and it resulted in creating superior services with lower charges which was followed by a remarkable increase in the number of lines. This privatization process also allowed the entrance of international companies into the local market of these three countries and increased competition and reduced margins. 

     Previously, Argentina, Brazil and Chile had been under dictatorship but in the mid and late eighties in had replaced by the democratic system. The economic of Argentina, Brazil and Chile had experienced major changes in last five to ten years and high inflationary environments gave more stable economies with recent annual inflation rate below 15%. 

     Lopez tried to consider the factors which have future impact on the changes in the telephone-directory business in the Latin American region for preparing the cash flow forecasts. He also considered the synergy like increased bargaining power when buying papers, printing efficiencies and partnership network with other companies all over the region. But one of the important factors Lopez did not consider when preparing the cash flow forecast was the ability that the single buyer would have to issue international debt on behalf of the three combined units. He also found that the telephone industry in Latin America there was no local “pure play” competitor and beta cannot be easily calculated for each country operation. 

     The valuation of the Paginas Amarelas was very difficult because too many problems had been faced by Lopez when he was trying to value the company. First thing he had to consider the future cash flows of the company. Second thing was that he takes an account of any type of benefits that the company can enjoy. 


     For estimating the cost of debt it had been found that the country operations never borrowed money at the corporate level but only at the country level. JP Morgan didn’t issue debt internationally and rely only on local markets for their borrowings. 

     The last step for determining the cost of equity, Lopez could choose between two different approaches under the CAPM method (Capital Asset Pricing Model). The first approach was to apply local market’s parameters considering local risk-free rate, local market premium and beta. The second option was to use US market parameters to estimate the cost of equity and adjusted it with an estimate of country risk arising from the local political and capital market environment. This last approach was considered by Lopez for determining the cost of equity. But the adjusting factors which were used reflect higher risk offered by equity investment in Argentina, Brazil and Chile. In such situation Lopez found some difficulties of applying the appropriate “adjusting factors”. 

     The valuation problems those have been faced by Juan Lopez are given below:

  • No Local “pure-play” competitor:   

                 o  As there was no strong local competitor, beta cannot be easily calculated.

                 o There were mostly private companies and number was too small for comparison and cannot use Capital Structure comparisons.

                 o Most companies owned other types of businesses rather than telephone-directory company.

  • Cost of equity:

                 o Risk free rate for each country was difficult to determine

                 o Market risk premium (return on market minus risk free rate) was questionable because local equity markets were not efficient.

                 o Cost of debt calculated on the basis of borrowings. But the company never issue debts internationally; they mainly relied on local markets for borrowing. 

     The cash flows were forecasted here in local currencies and US dollars. In first step the cash flows were calculated in local currencies and then converted to US dollars. Cash flows were projected in nominal local currency, taking inflation into account. The forecast of the exchange rate (the forward rate) between the dollar and local currency was based on Interest Rate Parity, which assumed that the exchange reflects differences in the inflation rate between two countries.  Cash flows were then concerted into US dollars using the estimated exchange rate for each period. 

     JP Morgan used US$ rather than to use local required rate of return to discount cash flows for all three countries because of highly inflationary currencies. 

     To estimate the required rate of return by using WACC method, the factors that should be considered is the cost of borrowed money. No international debt had been taken on behalf of three country operations together as the telephone-directory subsidiary but JP Morgan relied on the local markets for their borrowing needs. So the local borrowing rates, tax rates and long term capital structure should be taken into account for estimation. 


     Estimating the cost of equity under CAPM method there are two approaches. The first approach is to use local market parameters such as local-risk free rate, local market premiums and beta. The problems those had been faced were to determine the risk-free rate and estimating the equity risk premiums for each country. Historical data on equity market and key competitors in the industry should also be considered when estimating the required rate of return. 

     The second approach is to use US market parameters to calculate the cost of equity which will then be adjusted to reflect the country risk and this country risks measured from the local political and capital market environment by using “adjusting factors”. 

     The valuation process of Paginas Amarelas was in question whether the approach that had been used was appropriate or not. Because there should be some modification of the valuation methods using various adjusting factors in estimating cross border rates of return.