18880vol.1 Oct.1997

Proposal for a Joint Venture ECONOMICbetween a Multinational DEVELOPMENTCompany and a Local INSTITUTETobacco Factory

Djordjija Petkoski of the World Bank

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Proposal for a Joint Venture between aMultinational Company and a Local Tobacco Factory

in an Economy in Transition

Djordjija Petkoski

Regulatory Reform and Private Enterprise DivisionEconomic Development Institute

October 1997

Copyright (C 1998The International Bank for Reconstructionand Development/The World Bank1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

The World Bank enjoys copyright under protocol 2 of the Universal Copyright Conven-tion. This material may nonetheless be copied for research, educational, or scholarlypurposes only in the member countries of The World Bank. Material in this series issubject to revision. The findings, interpretations, and conclusions expressed in thisdocument are entirely those of the author(s) and should not be attributed in any mannerto the World Bank, to its affiliated organizations, or the members of its Board of ExecutiveDirectors or the countries they represent.

670/049 E 1993

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Employee Safety ........................................... 22MARKETING, SALES AND DISTRIBUTION ........................................... 22

Current Market Analysis ........................................... 22Product Quality and Strategy ........................................... 22Distribution ........................................... 23Marketing and Advertising ........................................... 24

PRO FORMA FINANCIALS ........................................... 24

Exhibits and Figures ........................................... 25

2

PROPOSAL FOR A JOINT VENTURE BETWEEN A MULTINATIONAL

COMPANY AND A LOCAL TOBACCO FACTORY

IN AN ECONOMY IN TRANSITION

Introduction

Peter was glad that he was selected to participate in the second module of the EDI seven-part training program on Enterprise Management for Restructuring and Privatization.The selection was exacting, but his hard work before and during the first module paid offFrom 64 participants in the first module, only 30 were selected to continue the program.During the month-long program, he did not get much sleep, but he learned a lot.Accounting and corporate finance became his favorite topics. The only problem he had toresolve immediately was how to prepare a business plan with his colleagues from thetraining program, which was a requirement for participation in the second module. Oneof his colleagues was an enterprise manager who was very interested in developing abusiness plan for his company.

Peter went to his boss to ask for flexible working hours while he worked on thebusiness plan. "Out of the question," was the short answer of his boss. "You have alreadyspent too much time this month on your training - in total, over two weeks. We havework to do here. The representatives of the Multinational Company are coming in threemonths to discuss their proposal for a joint venture with the local tobacco company. Theformal proposal was received yesterday, and we have to work on it."

Peter was deeply disappointed, but he was not in a position to argue. Onlyrecently, immediately after graduation, had he joined the Ministry of External EconomicRelations. He was a member of the group for foreign investment. Although his countryhad abolished the central planning system and had gone through democratic electionsseveral years ago, not many foreign investors expressed significant interest in his country.A number of small and not very promising investors had spoken to the Ministry, but nosubstantial agreements had been signed. Peter thought that maybe one of the reasons forthis lack of interest was that privatization was being implemented slowly. He thoughtanother reason might be that most of the enterprise managers were not capable ofpreparing feasible business plans. Their lack of enterprise management skills in anemerging market has been very evident.

This void motivated Peter to apply for the EDI training program. At first his bosshad serious reservations about the idea. "You work in a ministry, not in an enterprise.You don't need that type of training." Peter managed to convince him that this type ofknowledge is extremely relevant for them. "How can we be involved in policy decisionsand implementation if we don't understand what managing an enterprise in a marketeconomy is about?" was his main argument.

3

Multinational Company Investment ProposalFor Local Tobacco Factory

Overall Approach

Internationally known Multinational Company (MC) is interested in jointlycollaborating with Local Tobacco Factory (LTF), which is situated in a country whoseeconomy is in transition. This is to be the first MC investment project in this country. MCand its sister company are committed to developing diverse businesses in this region and areinterested in other potential projects.

The government of the country is interested in proceeding rapidly with theprivatization of selected industries and in encouraging an influx of foreign, private sectorcapital investment to help revitalize the country's economy.

In order to guarantee the long-term success of LTF and to enable it to compete withimported products, it should develop the capability to produce international qualitycigarettes as well as traditional products. Growth in and development of the existingbusiness of LTF will benefit the country, the factory's region, and the employees andmanagement of LTF through larger revenues to the government, substitution of localproducts for imports, enhanced prosperity for the community and LTF personnel, transfer oftechnical and management expertise to the country's agro-processing industries, and anincreased supply of cigarettes for domestic consumption and export.

MC proposes to link its major investment program for LTF with the simultaneousprivatization of LTF, thus creating a model for similar privatization programs in thecountry. This approach can be negotiated and implemented rapidly. This program isexpected to act as a magnet that will attract other international investors to the country.

This investrnent proposal is preliminary and is intended to assist in discussions andnegotiations. This proposal is supported by the management of LTF; it is based on guidancefrom specialist advisors to the government and industry of the country and on MC'sextensive worldwide experience in the cigarette and agricultural industries.

MC has approached LTF for several reasons:

* The country provides a stable political environment that seems to promise asmooth transition to a market economy.

* Current MC manufacturing facilities in Europe and the former Soviet Union areclose to full capacity, and MC needs additional capacity in the region.

* The LTF management team has the skills, qualities, and strengths with whichMC can work successfully as partners.

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* LTF is one of the few manufacturing enterprises in the economies in transitionwith a strong enough potential for modernization to meet MC's standards forinternational quality products.

* Regional government officials have been extremely receptive and supportive ofMC-LTF project discussions.

Cooperation with MC will provide tremendous advantages to LTF upon itsintegration into the MC network of affiliated businesses. As a large worldwide tobaccocompany, MC can provide LTF with significant advantages in acquiring quality tobaccoand materials at low cost, technical assistance in processing and production, and strength inproduct development, management, marketing, and distribution.

Benefits of the Investment Program

MC proposes to bring these key benefits to LTF, the region, and the country:

* Rapid negotiation and implementation of a visible and substantialinvestment project will attract other foreign investments to the country.Excise and income taxes and greater economic activity caused by MC'spresence and investments in LTF and the regional community will increasecontributions to the state budget.

* Imports of cigarettes and tobacco will be reduced through LTF's increasedproduction capacity and quality and an estimated reduction of tobacco wasteequal to at least 10 percent of the total tobacco throughput.

* Employment levels will substantially increase because of increasedproduction capacity.

* Cigarette production output will nearly double, over 27 billion units, by thethird year of the project.

* Development of a Tobacco Agronomy Program will increase agriculturalproductivity in the country.

* Improved processing and packaging technologies will be introduced andtransferred to the agro-processing industries of the country.

* Financial reliance of LTF on state assistance for imported materials will bereduced as MC's network takes on this responsibility.

* An influx of Western management and technical training will enhance thequality of the regional work force and will set an exarnple for regionalindustry.

* MC will sponsor community education programs.

Benefits of MC as Partner

MC is a world leader in the manufacture and marketing of consumer packagedgoods and is one of the largest consumer companies in the world, producing several famous

6

cigarette brands. These brands are enjoyed all over the world and have a growingconsumption in the country.

MC is the strongest possible ally for LTF and will enable it to face the challenges ofthe restructured regional tobacco industry successfully. In the last several years MC hasestablished a range of joint ventures in some countries in transition. MC proposes to use thisexperience to lead LTF into the 21st century as a consumer-oriented company producingunsurpassed quality products at affordable prices.

* Wealth creation - MC's strengths as outlined earlier will ensure thedevelopment and future profitability of LTF in an extremely competitiveenvironment. Through the combined efforts of planned activities in andaround LTF the employees of LTF can be assured of maximum professionaldevelopment and premium compensation. The local economy will benefit asLTF expands its business activity and investment.

* MC's commitment to the community - MC has a reputation as a modelcorporate citizen in the communities around the world in which it hasactivities and understands the value of contributing to communityeducational and cultural organizations. Traditionally MC presents a gift ofwelcome to the community in which new ventures are established. MCwould like to contribute to the development of young civic and businessleaders in the country and will work with local authorities to find anappropriate venue for this work.Emerging market economies - MC already has several investments incountries with economies in transition.Commitment to compete globally - MC is active in more than 150countries and competes successfully with other international cigarettecompames.

* Commitment to local management and employees - MC recognizes thetalent and quality of the existing LTF management and employees and willprovide additional resources to enable the organization to grow significantlyin the future. MC will maintain and work with local management andemployees to achieve the strategic objectives set out in its business plan, anapproach that is unique to MC and that is implemented in all of itsoperations worldwide. For instance, in the first joint venture (JV) in acountry with an economy in transition, MC increased employment by over25 percent in the first year of partnership operations.

* Strong worldwide brand portfolio - MC has several international brandsthat have substantial market share in many countries around the world,including those with economies in transition. A selection of MC's brands areplanned for production at LTF by the second year of the project.

* Experience in diverse markets - With its global presence, MC hasexperience in working with diverse cultures and markets. MC's operations

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in each of these countries are staffed and managed with local personnel.Each site is supported by a tight network of MC international business andmanagement contacts.

* Technology leader - With its significant R&D operations and facilities, aswell as its substantial investment in financial and human resources, MC isone of the world leaders in all areas of tobacco technology.

MC is the best international partner for LTF. MC is large enough to have achievedglobal market penetration, an unmatched level of technological expertise, and extensiveexperience in diverse markets, but not so extensive as to maintain LTF's identity in its owncountry by generating most of its products specifically for the country's market.

LTF and MC need each other. The joint venture will provide LTF with expertise,international products, and investment capital to meet the challenges of the newenvironment and will give MC additional manufacturing capacity to provide products for itsgrowing markets.

Other Potential Benefits

The geographical positioning of the country and the city in which LTF is situated, aswell as the vast markets of the economies in transition and the stability of the country withits highly educated work force, make the region highly attractive to commercialdevelopment. Following the start-up of the MC-LTF project, several related investment anddevelopment projects have been identified in which MC would be interested:

- Development of modem business hotel accommodations at an existing hotelin the city in which LTF is located;

- Development of a secure bonded warehouse facility in the city for storageand distribution of imported products and materials for the country andneighboring markets; and

* Investigation of potential development projects in sectors related to MCactivities such as the production of packaging materials used in theconsumer goods industry and the processing of materials used in thepackaged foods industry. Some projects could be developed in the area offood production.

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Joint Venture Investment Proposal

Introduction

LTF and MC propose to establish a tobacco joint venture (JV) in the country withan economy in transition with the principal objective of expanding LTF's existing cigarettemanufacturing business. The proposal calls for the simultaneous privatization of LTF withthe JV and petitions the government of the country to pursue this project rapidly as aprecedent-setting case for the privatization of the country's industries.

In order to modernize LTF's production facilities to increase output and improveoperating efficiencies, a major capital investment program is required. LTF has no ability tofund such an undertaking because of the high commercial risk created by the transformationof the country's economy.

MC is both capable and willing to invest in the redevelopment of LTF's facilitiesbut requires a degree of management control and a reasonable financial return from theprofits of the enterprise. MC believes its expertise in the tobacco industry worldwide willprovide some degree of assurance that it can generate a financial return sufficient to coverthe cost of the investment.

The financial projection shown later in the financial forecast has been developed onthe basis of an optimistic business outlook and assumes a rapid solution to the problemsinherent in the country's economy today. As these problems are very real and serious, it ispossible that these financial returns will be somewhat diminished. For this reason, MCbelieves that the proposed management control and sharing of profits is favorable for LTFand the country.

The JV contemplates full operations on a local currency basis with a major portionof annual profits to be re-invested in the business during the initial years to build a strongworking capital base, necessary to enhance profitable operations and growth.

Investment Philosophy

There are two possibilities: to have a pilot privatization or a traditional joint venture.

Pilot Privatization Option

The project postulates the formation of a JV by LTF and MC with the immediateprivatization of the state-owned assets of LTF. This approach is preferred by both MC andLTF management and has considerable benefit for the government of the country increating a model investment and privatization project to serve as a magnet for furtherinvestment and privatization in the country (see Diagram 1).

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DIAGRAM 1- PILOT PRIVATIZATION OPTION

LocaTobacco

Factory (LTF)

37% equitv

Local TobaccoFactory Assets

MC-LTF

Joint Golden

MC Investments: Stock Share Government

Capital Expansion CompanyManagement Systems

and Technology

63% equity

MultinatoaCompany

(MC)

JOINT STOCK COMPANY. The JV will be implemented through a newly created,closed joint stock company (MC-LTF JSC); 37 percent of the stock will be held by themanagement and workers collective of the state-owned LTF, and 63 percent will be heldby MC.

GOLDEN SHARE. In order to assure the government of the country that commercialmanagement of the JV does not conflict with the general interests of the state, a goldenshare of the JV can be held by the government with certain negotiated controls.

Traditional Joint Venture Option

If this pilot privatization option is consistent with government policy regarding LTFand the tobacco industry, MC would agree to a more traditional joint venture option wherethe government would maintain a stronger active interest in the business. The projectconcept would be similar to that discussed in the following sections, except that thegovernment's golden share would include 37 percent of the joint stock company created bythe JV, as in Diagram 2.

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DIAGRAM 2 - JOINT VENTURE OPTION

MC Investments: LocalCapital Expansion Tobacco

Management FactorySystems and Technology Assets

MC-LTF Joint Stock Company

37% equity Golden Share 63% equity

MultinationalGovernment Company (MC)

Paid-in Capital

MC shall make the following contributions, which will constitute paid-in capital forits 63 percent equity stake of the MC-LTF JSC:

3 Additional production equipment to improve and expand LTF's currentcigarette manufacturing capacity

* Capital for upgrading or replacing designated tobacco primary processingequipment

* Filter-making equipment* Spare parts* Cigarette manufacturing materials* Working capital support* Improvements in factory buildings and necessary ancillary equipment

(generators, boilers, etc.)* Technical expertise* Marketing and management know-how* Specific industrial property rights* Training programs for specific manufacturing and administrative personnel

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LTF will make the following contributions, which will constitute paid-in capital forits 37 percent equity stake in the MC-LTF JSC:

* Present production, administration, and warehousing facilities* Machinery, equipment, inventories, and stocks* Land-use rights* Inventories and stock* Work force* Any and all other assets under the control and use of the factory (such as

kindergartens, clubs houses, dachas, and employee apartments)

Management Structure

MC-LTF JSC will be managed by a five-member Board of Directors. The Board ofDirectors will be appointed by the shareholders, with the country partners appointing twomembers and MC appointing three members.

MC envisions temporarily assigning expatriate managers to work with localmanagers, particularly in finance, marketing and sales, and production management. Theseexpatriate managers will be expected to train local managers in Western (MC) managementskills and systems within the first few years following start-up so that expatriate managerswill no longer be required (see Management and Employee Programs).

Preliminary Assessment of Investments

The total volume of MC investments will be made during four years and is equal toUS$88.8 million. For detailed information about MC's projected investments in the MC-LTF JSC, see Exhibit 1.

Project and Investment Implementation Schedule

The implementation schedule for MC-LTF JSC covers four phases (see Table 1:Investment Implementation):

Phase I

Finalization and signature of agreements and the charter (January-February of theproject's first year)

* Agreement and signature of investment program TEO* Negotiations of founding agreement and JSC, including charter fund

contribution annex and other annexes

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* Signature of foundation agreement and JSC charter conditional on: (a) boardapproval and (b) approval by the government of the country

Phase II

Registration of JV and MC-LTF JSC (March)

* Founding meeting and election of Board of Directors* Registration of JSC* Contribution to paid-in capital in accordance with the founding agreement

Phase III

* Conversion of LTF from a state enterprise to a private enterprise owned by thenewly formed JSC (April-May)

* Conversion of LTF into a private enterprise via the pilot privatization

Phase IV

MC-LTF start-up and development program implementation (April-May)

* MC-LTF start-up* Immediate active program to provide critical raw materials and spare parts* Refinement and implementation of production strategy* Implementation of equipment refurbishment and investment program

TABLE 1: INVESTMENT IMPLEMENTATION':

Year I Year 2 Year 3 Year 4

Building Improvements I, II, III, IV II, III

General, Computers, Utilities II, III, IV I, II, III I, II, III, IV

Primary Processing III, IV I, II

Spare Parts II, III I, IIMaking and Packing Overhaul III, IV I, II, III

Add Making and Packing Lines III, IV 1, II, III

Equipment Replacement Program III, IV III, IV III, IV

Filter-Makers Addition III(I-IV indicate year quarters)

The above timing is indicative of MC's planned expansion of LTF. This timing depends on the equipmentsuppliers' ability to provide and deliver equipment within the target deadlines. It is anticipated that minordeviations could occur to this schedule on a year-to-year basis.

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Production Volume Forecast

Full production capacity, including the installation of additional lines of 27.1 billionunits, will be reached by Year 3. See Exhibit 8.

Financial Results Forecast

See Exhibit 7.

Local Partner Development Program

Local partner development program consists of several elements, discussed below.

General Strategy for Development

The overall strategy of the development program has the following majorobjectives:

Manufacturing Operations

T o improve the technical capability of LTF quicklyTo upgrade the LTF manufacturing plant so that it can produce superiorquality local cigarettes with vastly improved efficiencies of productionTo more than double the current production capacity of the factory anddevelop the capability of producing international quality cigarettes over thenext two to three years

Tobacco and Material Supply

* To implement barter trading operations quickly to assure the supply of allrequired raw materials at levels to assure the production of consistent, high-quality productsTo integrate the MC-LTF supply system into MC's regional supply networkto take advantage of the volume buying power of MC in purchasing high-quality materials at the best possible prices

* To work with the country's suppliers of materials, if required, to improvethe quality and efficiency of their operations, thus minimizing the need toimport materials

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Management and Employee Development

* To install computerized financial, accounting, and production managementsystems and train the appropriate personnel in their use so that seniormanagement has access to management information required for the fastchanging commercial environment

* To implement training in and systems of modem material management andproduction flow for efficient operationsTo implement a revised compensation program to reward the mostproductive workers and motivate the entire work force

Marketing, Sales, and Distribution

* To refine a business strategy focusing on current production brands with long-term potential for growth in the region

* To implement quality improvement initiatives for gradually improving theproduct line in terms of taste, smoking characteristics, and brand image

* To implement a sales and distribution system capable of assuring that MC-LTFproducts are delivered to all appropriate retail locations across the country aswell as to neighboring export markets

* To develop a new international quality country's brand with internationalmarket potential.

Production of local brands will be expanded to the maximum levels attainable onexisting equipment in order to meet the strong market demand for inexpensive papirossi andplain and filter cigarettes. Additional capacity and improved production will be achievedthrough the installation of modem high-efficiency plant equipment.

Manufacturing Operations

Manufacturing operations consists of several elements, discussed below.

Objectives and Programs

KEY OBJECTIVES. The key objectives of the new MC-LTF manufacturing operationswill be:

* To maximize manufacture of traditional product lines (papirossi and ovalnon-filters) for the country's market and for export barter to finance importsof raw materials;

* To improve quality significantly and install additional throughput fortobacco primary processing to provide capacity for 27 billion units perannum on a two-shift basis and to allow for international blend production;

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* To revitalize existing Western making and packing equipment; and* To move aggressively to install additional high-speed modem make and

pack capacity.

KEY PROGRAMS (YEAR ] - YEAR 4). The key programs for the first four years ofoperations include:

* Installation of computerized financial, accounting, and productionmanagement systems and training of required personnel

* Immediate purchase and use of necessary spare parts to achieve plannedproduction levels on all Western equipment lines

* Overhaul and refurbishment of all existing make and pack production lines* Installation of additional modem high-speed filter cigarette make and pack

equipment lines with an output of 9.4 billion units* Gradual replacement of existing cigarette make and pack equipment as

necessary* Replacement of existing one-ton capacity tobacco primary processing lines

with a new high-capacity unit to achieve higher output of high-quality cuttobacco filters and to produce international type tobacco blends

* Installation of additional cut filter silos* Build up of spare parts inventory to ensure continuous operation of

equipment* Installation of modem filter makers with sufficient capacity for 10.8 billion

units of filter cigarettes per annum

Primary Processing

ExSTING EQUIPM;ENT. The existing tobacco primary processing system will beimproved considerably by:

Installing an on-site steam plant with input water treatment;Refurbishing steam supply lines to and controls for existing vacuumchambers, conditioning drums, and re-drying cylinders; andModifying equipment to incorporate tobacco by-products into cut-filterblends.

These improvements will be made on an urgent basis following the JV start-up inorder to maximize the quality, filling-power, and throughput of the five existing 0.85 tonper hour primary lines.

ADDITIONAL CAPACITY. Additional primary processing capacity is required to fulfillthe projected production volumes anticipated by Year 2 and to replace the existing capacitywith higher efficiency modem processing. This high-capacity primary line will be installed

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in re-constructed space in the warehousing facility near the existing primary processingworkshop. Additional cut-filter storage silos will be installed to provide maximumflexibility of manufacturing planning. The following activities will be undertaken:

* Reconstruction and site preparation of the new primary processingworkshopInstallation of a modem high-efficiency primary line with complete flowand process controls and international blend capability

* Installation of additional cut-filter storage silos

Cigarette Making and Packaging

The make and pack equipment is in moderate running condition; however, the oldmachinery for the unfiltered cigarettes continues to run at acceptable efficiency levels.Efficiency of the equipment producing filtered cigarettes (about 23 percent of totalproduction) is low (around 62 percent), and an extensive overhaul and equipmentrefurbishment program is required to improve efficiency and product quality levels. Theprogram will include:

Overhaul of all existing equipment of Western origin used for themanufacture of filtered cigarettes(Overhaul of existing Western-type packers1Build-up of spare parts inventory to cover one year of full operations, andImplementation of a modem manufacturing planning and reporting system,which will allow plant operation at maximum possible efficiency.

INCREMENTAL CAPACITY. The existing production building has sufficient space forthe planned additional make and pack lines. The additional lines will increase the capacityfor filtered cigarettes by 9.4 billion units per year. Incremental capacity includes:

. Installation of cigarette makers and packers in international king-sizeconfiguration, and

* Installation of the first line, anticipated for the fourth quarter of Year 1 with 9.4billion units of additional capacity available by mid-Year 3. The packageconfiguration will depend on commercial factors.

REPLACEMENT CAPACITY. Gradual replacement of existing make and pack capacitywill be implemented as market forces shift demand from traditional oval unfilteredcigarettes to filtered cigarettes. The investment budget allows for the replacement of about3.6 billion units of making and packing capacity between Year 2 and Year 4.

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Filter Making

In order to reduce the hard currency requirement for imported acetate tow filters,filter rod assembly equipment will be installed to meet the factories' demand for filters. Fordetails of projected filter production, see Exhibit 10. The balance of required filters (Years3-5) is anticipated for light cigarettes, requiring special filters to be supplied externally.

Quality Control

A modern quality-assurance laboratory and all necessary production floor qualitycontrol equipment will be installed. MC specialists will work with LTF management todevelop and implement procedures, specifications, and tolerances for quality control of rawmaterials, production, and finished products. Furthermore, technical and managementassistance will be provided to the local materials suppliers to assure improvements inquality material supply.

General Improvements

This includes site improvements and improvements in buildings and utilities.

SITE IMPROvEMENTS. In order to improve site utilization, the following steps will betaken:

Redefine areas of greenery, access roads, parking, and material handlingaccess (including loading and unloading facilities)Implement a complete site security system including fencing, electronicsafety device, and admission procedures (check in/out of vehicles andpersonnel). This refers to both the factory site in town and the warehousefacilities in the outskirts.

* Completion of paved area* Installation of a sheltered area for loading and unloading* Completion of loading and unloading equipment, such as lift trucks and

truck dock levers

BUILDIAGSAAD UTiLiTIEs. The following areas will be upgraded:

* Flooring* Windows and doors* Furnishing* New fire and security system

18

The urban steam supply will continue to be used to heat the buildings. To improvetobacco processing, a new on-site steam plant, including water treatment, will be installedto provide food and tobacco industry-quality steam.

In order to ensure the required power supply at any time, an on-site power generatorwill be installed. Furthermore, the total power consumption will be reduced throughappropriate building and process energy management.

A functional overhaul of ventilation, air conditioning, and dust extraction equipmentwill be necessary, accompanied by the replacement of existing duct work where necessary.

It appears that vacuum chanbers do not operate up to expectations because ofinsufficient vacuum capacity. The complete replacement of existing vacuum pumps is acontingency.

The existing compressors do not appear to have acceptable capabilities for the foodand tobacco industry. The replacement of these units with new machinery may benecessary.

Tobacco and Material Supply

Tobacco and material supply elements are described below.

Tobacco Supply Strategy and Usage Requirements

The factory purchases its tobacco on a contract basis with deliveries being fulfilledeffectively only for convertible currency payments or the equivalent in barter trade.

MC will work with LTF to procure tobacco from traditional suppliers as well as MCworldwide suppliers. All tobacco supplied can be procured through barter in exchange forthe export of MC tobacco products and other exportable goods produced in the country.

MC has begun to cooperate with tobacco growers and fermentation plants in othercountries with economies in transition to maximize the acquisition of tobacco from thetraditional trading areas of these countries.

Exhibit 9 represents projected tobacco use by the JV.

Tobacco Agronomy Development

To reduce the need for importing tobacco and to assist in the economic developmentof the agricultural sector of the country, MC will work with the growers of tobacco andsimilar crops to develop the full potential of tobacco growing in the country.

19

MC will integrate agronomy programs operating in other regions to providedevelopment assistance to farms in the country suited for commercial development oftobacco growing. In spite of climatic limitations on the commercial viability of tobaccoagronomy due to the length of the growing season, certain tobacco species are adaptable tolarge volume production with the appropriate support.

EXPERIMENTATION FARMS. MC will develop pilot growing schemes to select anddevelop varieties of tobacco most suited for commercial development in the country. MCwill work with the selected farm to develop proper planting, curing, and processingfacilities to produce high-quality tobaccos for international blend cigarettes.

PILOT PROGRAM. MC will commit to establishing the first such developmentprogram within six months of the JV's start-up. This program will include the followingfeatures:

* Farm and acreage selection for initial pilot crops* Seed bed preparation and selection of tobacco varieties- Implementation of initial crop planting with advisory assistance to

participating farmers and crop technicians- Development of curing facilities as required for initial crops-- Continued training and assistance to expanded groups of farmers- Expansion of the program with more farmers* Ongoing assistance

Other Raw Materials

Cigarette paper, tipping, and wrapping materials are purchased when possible fromdomestic suppliers. Acetate filter rods are being procured from abroad.

MC will work with the country's suppliers to improve their capability of producingquality components and will obtain imported components through barter trade from othercountries in economic transition.

Management and Employee Programs

MC will support the management of LTF through the participation of MC expatriatemanagers assigned to LTF, MC representation on the Board of Directors, and initially withan on-site integration team. The integration team will consist of a group of ten to fifteenhighly qualified MC experts from all business areas and from all over the world. Theyinclude primary processing specialists, making and packing specialists, quality assurancespecialists, inventory specialists, finance and management specialists, and computer andsystems specialists. In this respect, experience accumulated while working in othereconomies in transition will be used.

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Training and Development Programs

The JSC will be managed by a board comprising three MC nominees and two LTF(Workers' Collective) nominees. This board will nominate a general director who willoversee the management of MC-LTF operations. The principal priorities of themanagement team will be:

Rapid implementation of an appropriate management structure capable ofdeveloping modem and efficient controls and procedures for accounting,production, material procurement, inventory control, and personnelmanagement. This new structure will be supported by the appropriateautomation and systems.Development of a broad-based training program calling for Westernbusiness training for administrative staff and quality training for machineoperators and key production personnel.

These training programs will be conducted both on-site and at selected MC facilitiesworldwide. The overall objective of the management program is to strengthen the MC-LTFJSC qualitatively to ensure that it becomes a notable example of a successfully restructuredmarket-oriented competitive organization serving as a model for both regional and nationalindustry.

MANAGEMENTAND STAFF. Training will be given to staff as follows:

3 General Director - Two months' training in business administration; one monthof intensive English training per year for three years plus periodic ongoing training;MC internal management development program; other designated training programs

v Management - At MC facilities or elsewhere, training provided over the firstthree years of the JV; on-site training to finance staff and production staff

* Sales and marketing staff- Training for technical staff on an as-needed basis* Employees - On-site training for production operators as required, as well as at

selected MC facilities worldwide

Employee Compensation and Work Force Levels

MC will work with LTF management to review current salary levels. MCanticipates that salaries will be adjusted considerably within the first three months of the JV.MC-LTF intends to implement new systems of compensation including bonus paymentsand incentives to reward productivity.

Given the increased activity anticipated for LTF, the number of employees isexpected to rise.

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Social Facilities

MC has no current wish to dispose of any social assets belonging to LTF or tochange traditional practices of LTF in providing social services that are consistent withsimilar former state enterprises in the region. As these traditions change with the economicsituation, MC will assist in implementing sound realistic solutions that protect the interestsof LTF and its productive employees.

Employee Safety

MC has extremely high standards for safety in its production facilities around theworld. Primary safety concerns in a cigarette manufacturing operation are fire, industrialequipment accidents, and respiratory problems caused by dust levels. A safety audit will beconducted by an MC safety specialist to assure proper systems and operating proceduresregarding fire and industrial accidents. The proposed investment plan includes improvingthe air conditioning and ventilation system for the production areas, which will lower thedust levels considerably.

Marketing, Sales and Distribution

Marketing, sales and distribution consist of the following elements:

Current Market Analysis

The market for cigarettes in the country of project implementation is estimated to be21 billion to 22 billion units per year. The total projected output of LTF for Year 0 isestimated at 13.2 billion units.

The current cigarette deficit is estimated to be between 8 billion and 9 billion units.As a result, the JV's objective is to increase capacity. The planned product mix is presentedin Exhibit 11.

As part of the domestic market demand for cigarettes is expected to continue to bemet by imported products, a substantial portion of MC-LTF's production will be availablefor export to generate hard-currency financing for raw materials.

Product Quality and Strategy

All efforts will be made to ensure that the best quality products, produced within thecost limitations set by each product segment, can be commercialized successfully.

With the addition of improved tobacco processing equipment, the refurbishment ofcigarette-making equipment, and improved operating and maintenance procedures, product

22

quality and uniformity will be increased dramatically while product costs are reducedbecause of efficiencies gained in material usage. Better tobacco conditioning, flow controlfor feeding to tobacco cutters, and application of tobacco casings are expected to:

* Reduce tobacco usage and loss by over 10 percent of the total tobaccothroughput, significantly reducing the current LTF estimated waste rate of atleast 144 to 24 percent, and

* Assure quality products with fresh tobacco filler and with good burning andtaste characteristics.

It is anticipated that the cigarette market will move gradually towards the qualitylevel set by Western premium importecd cigarettes as the average income increases for thecountry and the region.

LTF management, working with MC marketing and product developmentspecialists, will refine the product strategy with the following objectives:

* Rationalization of the current production brands, focusing on those brandswith identifiable long-term market potential

* Development, introduction, and marketing support for a new filteredcigarette brand with a strong country brand identity using high-qualityconsumer packaging and professionally proven brand imagery andadvertising themes

* Introduction of international MC brands during the second year of the JVthrough imports.

MC will work with LTF management to detenrnine the best approach to promotinglocal brands and introducing selected MC internationally renowned brands.

Initial efforts will focus on maximizing production of low-priced local brands inorder to meet the demand of the local consumer market. MC will extend its branddevelopment efforts in progress in other joint ventures in economies in transition(production of international blend products) to the LTF venture.

Production and development of filtered cigarette brands will increase during thethree-year investment plan with the installation of the additional make and pack lines andappropriate filter equipment, which will increase the production capacity of filteredcigarettes to 13.9 billion units.

23

Distribution

Initial efforts for the development of MC-LTF distribution will focus on:

* Increased delivery to the state distribution network;* Development of sales to emerging private distribution channels;* Direct relationships with large commercial enterprises in the country and in

other economies in transition;* Participation in retail merchandising and sales, where feasible, with

development and training of a LTF sales force, further expandingemployment; and

* Distribution and sales offices will be opened in the capital and other keycities of the country. Liaison offices will be established in key exportmarkets in the countries with economies in transition.

Marketing and Advertising

Marketing and advertising campaigns will be developed quickly for key localbrands with registerable trademarks that can be defended under emerging trademark laws.This campaign will be concentrated initially on promoting the image of MC-LTF as aproducer of high-quality affordable cigarettes with the additional promotion of specificlocal brands. Marketing and advertising will be promoted aggressively to build currentbrands with identifiable long-term potential.

Pro Forma Financials

The following financial projections have been developed for indicative purposesonly, on the basis of approximate costs and prices anticipated for the first and second years,depending on domestic inflation and changes in currency exchange rates. The estimatedprofit generation is optimistic in the short term but considerable over the long term.

See Exhibits 1 through 7.

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INVESTMENT AND GROWTH OF SHAREHOLDERS' VALUE Exhibit I

Capital Investment/Expansion (US$ Thousands) Year 1-4 Year I Year 2 Year 3 Year 4 Year 5

Building and site improvements 2,484 1,242 1,242 0 0 0Primary processing improvements 20,700 5,175 15,525 0 0 0Overhaul of existing western make/pack lines 4,830 2,415 2,415 0 0 0Spare parts for existing western make/pack lines 2,300 1,150 1,150 0 0 0Additional cigarettes make/pack lines 27,600 4,600 23,000 0 0 0Equipment replacement program 10,350 0 4,140 2,070 4,140 0Filter-making equipment 4,968 3,312 1,656 0 0 0Computer/office equipment/expatriate housing/etc. 3,105 1,656 1,035 414 0 0Plant utilities (including steam and electricity) 1,380 0 0 0 0 0

TOTAL FIXED CAPITAL EXPENDITURE per year 77,717 20,930 50,163 2,484 4,140 0

WORKING CAPITAL 5,750 5,750 0 0 0 0

Non-capitalized foreign investments 5,325Training, development, and technical assistance 828 828 828 828 0Sales and marketing organizational development 863 575 575 0 0

TOTAL MC INVESTMENTS 88,792 28,371 51,566 3,887 4,968 0CUMULATIVE MC INVESTMENTS 28,371 79,937 83,824 88,792 88,792

GROWTH OF SHAREHOLDERS' VALUE 15,529 34,886 35,771 37,788LTF collective 37% equity value 26,440 59,401 60,908 64,341MC 63% equity value

25

INCOME STATEMENT FORECAST Exhibit 2

(US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5

Papirossi net sales 2,217 2,217 2,349 2,349 2,349Oval non-filter net sales 26,723 26,723 27,524 27,524 27,524Soft pack filter net sales 10,600 11,130 11,464 11,464 11,464CPB Filter net sales 9,263 35,664 47,402 49,771 49,771TOTAL UNIT VOLUME (Millions) 18,600 24,840 27,120 27,120 27,120

TOTAL REVENUE FROM NET SALES 48,803 75,734 88,739 91,108 91,108COST OF RAW MATERIALS 34,204 52,713 59,475 59,475 59,475% of net sales 70% 70% 67% 65% 65%

Distribution expenses 357 476 520 520 520Utilities 342 527 595 595 595Direct labor (wages) 753 1,006 1,098 1,098 1,098TOTAL VARIABLE CONVERSION COST 1,452 2,009 2,213 2,213 2,213

Salaries administration and production 374 499 545 545 545Payroll social benefits and taxes 462 618 674 674 674Commercial office expenses 46 46 46 46 46Spare parts (year I parts capital) 0 0 920 920 920Advertising and market budget 684 1,055 1,189 1,189 1,189Maintenance and office overhead 1,150 1,150 1,150 1,150 1,150Depreciation buildings and equipment 2,983 8,041 8,331 8,745 8,745R and D budget 0 0 0 0 0Training and development budget 0 0 0 0 0TOTAL FIXED OVERHEAD 5,699 11,409 12,855 13,269 13,269

PBT 7,448 9,603 14,196 16,151 16,151% of net sales 15% 13% 16% 18% 18%

TAX 33% 0 0 4,685 5,330 5,330

PROFIT AFTER TAX 7,448 9,603 9,511 10,821 10,821

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INCOME STATEMENT FORECAST (Summary) Exhibit 3

(US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5

Total unit volume (millions) 18,600 24,840 27,120 27,120 27,120NET SALES AFTER EXCISE TAX AND VAT 48,803 75,734 88,739 91,108 91,108TOTAL COST OF GOODS SOLD 40,671 65,076 73,354 73,768 73,768GROSS MARGIN 8,132 10,658 15,385 17,340 17,340Total marketing/advertising 684 1,055 1,189 1,189 1,189Selling expenses 0 0 0 0 0Administrative 0 0 0 0 0R and D/technical support 0 0 0 0 0OPERATING MARGIN 7,448 9,603 14,196 16,151 16,151Misc. oper. (income)/expense 0 0 0 0 0Business unit contribution 7,448 9,603 14,196 16,151 16,151IBT 7,448 9,603 14,196 16,151 16,151TAXES (33%) 0 0 4,685 5,330 5,330NET INCOME 7,448 9,603 9,511 10,821 10,821

PROJECTED CASH FLOW Exhibit 4

(US$ Thousands) Year 0 Year I Year 2 Year 3 Year 4 Year 5

Joint venture's equity injection [7,841] [26,680] [50,163] [2,484] [4,140] 0

Inv. equity (PV @ 5%) [80,265]Net income after tax 7,448 9,603 9,511 10,821 10,821Depreciation and amortization 2,983 8,041 8,331 8,745 8,745Incremental working capital [5,394] [6,028] [1,615] [89] 0Net residual book value 102,129

Annual cash flow generated [80,265] 5,037 11,616 16,227 19,477 19,566Cumulative cash flow [80,265] [75,228] [63,612] [47,385] [27,908] [8,341]

5-Year Basis 10-Year Basis

Cumulative cash flow net of invest. 71,924 172,411

Cumulative discounted PV @ 12% 48,791 67,332Project IRR (10 years) 20%Payback period 6 YearsAverage R.O.I. 18% 21%

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PROJECTED BALANCE SHEET Exhibit 5

(US$ Thousands) Pre-JV Start-Up Year I Year 2 Year3 Year 4

ASSETS

Cash (build-up from depreciation) 79 76 4,885 9,052 16,102 26,127Accounts receivable (8 days) 152 152 1,627 3,156 3,697 3,796Leaf and NTM's inventory (1.6 month) 253 253 4,561 8,785 9,912 9,913Finished product inventory (4 days) 29 29 813 1,578 1,849 1,899Other current assets 120 120 120 120 120 120TOTAL CURRENT ASSETS 630 630 12,006 22,691 31,680 41,855

Fixed assets 7,671 7,671 34,351 84,514 86,998 91,138Accumulated depreciation 0 0 [2,983] [11,024] [19,355] [28,100]Investments 0 0 0 0 0 0TOTAL PPE 7,761 7,761 31,368 73,490 67,643 63,038

TOTAL ASSETS 8,301 8,301 43,374 96,181 99,323 104,893

LIABILITIES AND EQUITY

Accounts payable 230 230 1,405 1,894 2,644 2,764Short-term loan (1) 230 230 0 0 0 0Long-term debt 0 0 0 0 0 0TOTAL LIABILITIES 460 460 1,405 1,894 2,644 2,764

Reserved fund 0 0 0 0 0 0Accrued dividends 0 0 7,448 9,603 9,511 10,821Collective equity 37% 7,841 2,901 12,773 31,333 32,252 33,784MC com. equity 63% 0 4,940 21,748 53,351 54,916 57,524Other equity 0% 0 0 0 0 0 0Retained earnings 0 0 0 0 0 0TOTAL EQUITY 7,841 7,841 41,969 94,287 96,679 102,129

TOTAL LIABILITY AND EQUITY 8,301 8,301 43,374 96,181 99,323 104,893

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GOVERNMENT REVENUES FROM THE PROJECT Exhibit 6

(US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5

Revenues from excise tax (56-58%) 62,222 102,472 121,624 125,180 125,180Revenues from VAT on cigarettes 0 0 0 0 0TOTAL EXCISE AND VAT 62,222 102,472 121,624 125,180 125,180

Income tax on TF profit 0 0 4,685 5,330 5,330

TOTAL REVENUES GENERATED 62,222 102,472 126,309 130,510 130,510

CUMULATIVE 5 YEARS 552,022

PROJECTED FINANCIAL RETURNS Exhibit 7

(US$ Thousands) Year I Year 2 Year 3 Year 4 Year 5

LTF revenues 2,756 3,553 3,519 4,004 4,004MC's revenues 4,692 6,050 5,992 6,817 6,817MC's investments [28,371] [51,566] [3,887] [4,968] 0Government's revenues 62,222 102,472 126,309 130,510 130,510

Cumulative LTF cash flow 2,756 6,309 9,828 17,836 17,836Cumulative MC cash flow [23,678] [69,194] [67,089] [65,240] [58,423]Cumulative government cash flow 62,222 164,694 291,003 552,022 552,022

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PRODUCTION VOLUME FORECAST Exhibit 8

(Unit millions) Before Year I Year 2 Year 3 Year 4 Year 5

EXISTING EQUIPMENTPapirossi 1,200 1,200 1,200 1,200 1,200 1,200Oval/non-filter 10,800 12,000 12,000 12,000 12,000 12,000Filter soft/box 1,200 4,560 4,560 4,560 4,560 4,560

ADDITIONAL EQUIPMENTProjected capacity* 840 9,360 9,360 9,360 9,360

TOTAL 13,200 18,600 27,120 27,120 27,120 27,120

PRODUCTION OF MC BRANDS 0 600 4,200 4,800 4,800 5,400

Additional capacity--foreign brands 0 240' 5,160 4,560 4,560 3,960

* Newly installed manufacturing line will reach 100% capacity of 9,360 million units by Year 3.

TOBACCO USAGE Exhibit 9

Year 0 Year I Year 2 Year 3 Year 4 Year 5

Production volumes (unit billions) 13,200 18,600 24,840 27,120 27,120 27,120

Estimated tobacco usage (kg/1,000 cig.) 1.15 1.05 1.00 0.95 0.93 0.90

TOTAL USAGE (tons) 15,180 19,530 24,840 25,764 25,222 24,408

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FILTER MAKING PROJECTION Exhibit 10

(Billion units) Year I Year 2 Year 3 Year 4 Year 5

Cigarette volumes 5.4 11.6 13.9 13.9 13.9

FILTER-MAKING EQUIPMENTTwo lines 3.6 7.2 7.2 7.2 7.2Third line 1.7 3.6 3.6 3.6 3.6

TOTAL 5.3 10.8 10.8 10.8 10.8

MARKET ANALYSIS Exhibit 11

(Unit millions)

PRODUCTION MIX CURRENT PRODUCTION PLANNED CAPACITY

Non-filter cigarettes 10,800 12,000Filter cigarettes 1,200 13,920Papirossi 1,200 1,200

TOTAL 13,200 27,120

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Figure 1

FOREIGN INVESTMENTS STRUCTURE (YEAR 1-4)

Computer and office Plant utilities (includingequipment, expatriate steam and electricity)

housing, etc. 2%4% Building and site

improvementsFilter-making equipment 3%

6%

Primary processingimprovements

Equipment replacement 27%program

13%

Overhaul of existingwestern make/pack lines

6%

Additional cigarettes Spare parts for existingmake/pack lines western make/pack lines

36% 3%

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Figure 2

12,000

10,000

Qw 8,000

en

o 6,000

0 4000~~~ ' ~~~1

2,00Oi

Year 1 Year 2 Year 3 Year 4 Year 5

33

Figure 3CUMULATIVE FINANCIAL RESULTS

First Bar = LTF Cumulative CFSecond Bar = MC Cumulative CF

Third Bar = Government Cumulative CF

600,000

500,000

.n 400,000

CI 300,000 - __ __ _ __

i- 200,000

, 100,000

-100,000

Year 1 Year 2 Year 3 Year 4 Year 5

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The Economic DevelopmentInstitute (EDI) was establishedby the World Bank in 1955to help promote internationaldevelopment. EDI conductslearning programs for officialsfrom developing countries toassist them in planning andmanaging their investmentsmore productively. The Instituteproduces and disseminatespublications and electronicinformation products thatsupport these objectives.

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