Income Statement and Debt

GBATT Income Statement Review

GBATT has a relatively stable company. It saw revenues decline 4.4% and profits by 4.24% last year. Expenses dropped in lockstep with revenues, indicating that the company has good ability to respond to changes in the prevailing economy. The company still earned a healthy net margin of 12.6% last year, despite the apparent economic downturn.

There are several factors to consider when making the decision to enter the Brazilian market. If the decision to enter has already been made, then the company still has to consider the method of financing for the expansion. Debt better aligns the cash inflows incremental to the project with the outflows. However, debt may come with restrictive covenants, and furthermore depending on the method of debt financing the company might be exposed to different types of foreign exchange rate risk. Equity, on the other hand, comes at a higher cost than the cost of debt.

If debt is chosen as the means of financing this expansion, there are a few additional considerations to take into account. The first is that the debt can either be centralized or decentralized, that is to say that the debt can be entirely from the U.S., entirely from Brazil or it can be obtained as a mix. The benefit to decentralized financing is that the project will earn revenues not just from Brazil but from the rest of South America as well. As such, inflows are not just going to be in reais but in many currencies. To decentralize the debt allows for a reduction in foreign exchange rate risk -- centralized real debt means translating, third-country currencies to BRL and then to USD.

The company appears to have a low level of debt, based on the current interest expense. As such, it is recommended that decentralized debt financing be used. Real-denominated debt should be floating, to minimize interest rate risk on that volatile currency. The real-denominated debt should be in an amount roughly equivalent to expected future cash flows from Brazilian sales. The remainder of financing should be in USD, to reduce F/X risk. USD financing should be obtained domestically, and should be at a fixed rate, as there is expectation of multiple rate increases in the U.S. in the coming months and years.

Introduction

The following report will highlight GBATT's financial performance, based on a review of the income statement. The report is based on the context of a potential expansion to Brazil in the coming quarters.

Operational Performance

GBATT saw a decline in revenues last year, which is normal given that we are apparently experiencing a global economic downturn. The decline in revenue filtered through the rest of the income statement, and the company also saw a decline in net income. The decline in revenue was 4.4%, or $200 million. The decline in net income was $24.1 million, or 4.24%. The other line items were the same in terms of their percentages of sales. This means that the decline in net income is wholly attributable to the decline in revenue, as the percentage for items such as COGS did not change.

All told, the company was able to successfully hold the line on its costs during the past year, even in the face of declining revenues. By being able to reduce costs in step with the decline in revenues, the company was able to avert a bigger negative impact on the bottom line. This shows excellence management, to have been able to anticipate the downturn and structure the company's operations for the year accordingly. All told, if revenues increase in the coming years in the domestic market, then the profit should also increase.

Funding Choices

There are a number of different financing options for the new plant. There first choice is actually whether to secure financing in Brazil or to do so in the U.S. and invest cash. The main advantage of securing financing in Brazil is to reduce foreign currency risk exposure -- financing in reais can be paid off with revenues in reais, creating an operating hedge (Picardo, 2016). If the company chooses to finance in U.S. dollars, then it may have to expatriate some of the earnings from Brazil to cover the interest. This will incur with foreign exchange rate risk and it will incur transaction costs. There are major international banks in Brazil such as Santander, Paribas and HSBC, so there is no need to be overly concerned about dealing with some unknown developing world bank. It should be noted that even if the company uses such an operating hedge to eliminate transaction risk, it will still face translation risk on its income statement, due to its full ownership of the Brazilian subsidiary.

There is also the option to issue debt in both currencies. Issuing in a single denomination is known as centralized borrowing, while issuing in multiple is known as decentralized. There are a couple of dynamics at work here. First, decentralized allows the company to reduce its exposure to the real, while maintaining at least a partial operating hedge. Remember that the reason the company is considering using debt in the first place to better align the inflows from the project with the outflows. For GBATT, the question of decentralization has to reflect where it thinks those inflows will come from. If all of the inflows from the project are going to come from Brazil, then that reduces the strength of the case for denominating some of the debt in dollars. However, if the factory is going to produce for the entire South American market, then it makes more sense to have the debt partially decentralized, because revenues are going to come in from a variety of different currencies. In South America, the USD is the main hard currency. Selling to all South America makes the case for decentralized debt.