Case Analysis - Compania de Telefonos de Chile

Compania De Telefonos De Chile

COMPANIA DE TELEFONOS DE CHILE CASE ANALYSIS

Submitted by: 1. Ankan Mitra – MP 13012 2. Shubhayu Sanyal – MP 13056 3. V Satish – MP 13066 4. Jasbir Singh – MP13027 5. Kunal Ranjan – MP13032

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Compania De Telefonos De Chile BACKGROUND: Recently privatized Chilean telephone company, Compania de Telefonos de Chile (“CTC”) was in the midst of an ambitious expansion cum modernization plan in 1989-90. The Vice President (Finance) Sr. Garcia was evaluating the best option to raise capital to fund the plan. He was responsible to propose a plan to the Board of Directors to raise substantial new funds externally in order to finance the expansion program of the organization. The expansion program was absolutely necessary for CTC as the telecom market of Chile was developing and the demand for better telecom services was growing in this Latin American country. CTC, an erstwhile government undertaking, has been divested and was acquired by Alan Bond, an Australian entrepreneur. Alan wanted to transform the company into a modern state of the art undertaking with high tech telecommunication capabilities. He wanted to reduce substantially the time needed to install telephone services and fasten the rate of digitization and internet connectivity. However, Alan Bond ran into significant personal financial distress and could not meet the debt obligations of the company after its acquisition and had to eventually sell off the shares of the company to a Spanish telecom player who decided to undertake the expansion program. The infrastructure development associated with the expansion program would help CTC to capitalize on the untapped demand and become the primary telecom player in Chile. The task for Sr. Garcia seemed complicated on account of Chile’s small, illiquid financial institution namely the Stock Markets and lending banks and the skeptical view held by investors of the developed nations about Latin American companies.

CTC’S FUND REQUIREMENTS CTC is in need of funds as it is in the middle of an aggressive expansion program which requires substantial capital resources. Further, CTC is also required secure the funds for a period of 5-7 years and therefore any adverse effect by the company or the market may jeopardize the expansion program. The expansion program includes substantial reduction in the time to get telephone service, and expansion of the capabilities of the company to provide some of the latest high-tech capabilities in the telecommunications industry.

Unfortunately, internally generated funds for CTC were not sufficient to meet the requirements of the expansion project. As a matter of fact, there are barely any internally generated funds as CTC had a policy Case Study

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Compania De Telefonos De Chile of distributing 100% of its income to its stockholders as dividends. The new Management took the decision to reduce the rate of dividend to 60% in order to enhance the retained earnings to fund the expansion projects. However such retention was far from being adequate and could not eventually meet the requirement. Hence, CTC had to look for alternative sources of funds. Sr. Garcia evaluated several options to raise external funds. They were: 1. Through equity raising exercise in the local capital / stock market or 2. Borrowing from the local Chilean Banks or 3. From foreign prominent lenders or 4. From the overseas equity market through the listing of American Depository Receipts (“ADR”). However, each of the above options had their unique drawbacks! CTC could raise domestic funds in Chile through the first two options, but there were doubts whether the country’s financial market could fully finance the entire requirement of funds of the telecommunication giant. First, the local stock market was relatively small. Second, Chilean banks were small and that they were legally restricted from committing substantial funds to just one company (not more than 25% of its capital and reserves in a single entity), and also if they were allowed to do so, that would mean a very high exposure to CTC alone. The third option was less feasible as the foreign commercial banks shied away from investing in the Latin American companies after the debt crisis in the 1980s and subsequent large scale debt write-offs in Latin America. Hence CTC is forced to look for the funds outside Chile and the viable option left with Sr. Garcia was raising the overseas equity through ADR.

AMERICAN DEPOSITARY RECEIPT (“ADR”) An ADR is a certificate of ownership issued by a U.S. bank to promote local trading in a foreign stock. This means that the United States’ bank holds the foreign shares of stocks and issues American Depositary Receipts against them which it then sells to American investors. However the ADR can also be three types of which the “Level I” ADRs were introduced as unlisted securities that could trade by dealers over-the-counter. Issuing firms could qualify for financial reporting exemptions and did not need to register fully with the SEC; however, no capital raising was permitted. “Level II” ADRs and “Level III” ADRs register and disclose financial statements exactly as domestic U.S. companies in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). But only Level III ADRs are permitted for capital raising. However ADR also posed several challenges for Sr. Garcia in view of the fact the Case Study

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Compania De Telefonos De Chile stocks might flow back to home market during recession causing suspension of trading and the subsequent falling of the stock prices. Further since the investors are from US markets and there is no precedent to evaluate any Chilean company, they have lesser knowledge regarding the potential of the telecom market in Chile. Further Sr. Garcia was skeptical whether CTC can meet the reporting standards of the Level III ADR.

PROBABLE SOLUTION Apparently, all the three levels of ADR were not in sync with the requirement of CTC. The ideal option for Sr. Garcia to propose would be the ADRs under Rule 144A wherein the equity could be raised through private placement of the ADRs and it would not require the registration and mandatory disclosure under the GAAP. It was designed to serve a number of purposes including increasing the overall liquidity of private placement securities. This would help CTC to connect with private investors having the knowledge of the telecom sector of Chile. Further these securities have the advantage of trading over-thecounter. Since this option was likely to be available after June 1990, till such time Sr. Garcia may arrange for short term borrowings through the local Chilean Banks to facilitate the initial cash flow to the expansion program. Though this route has a significant cost to company USD 200,000 – 400,000, the benefit from increased liquidity and permission to place and trade privately among large, sophisticated institutional investors would outweigh the cost.

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