Cases - Problems Module 4 - 2011

Module 4: Multinational Capital Budgeting
Inputs for Multinational Capital Budgeting

Initial investment
Consumer demand over time
Product price over time
Variable cost over time
Fixed cost over time
Project lifetime
Salvage (liquidation) value
Restrictions on fund transfers
Tax payments and credits
Exchange rates
Required rate of return
WACC computation:
(1+Rf of country A) (1+Risk Premium of country A) = (1+WACC of country A)
Risk adjusted country Bs currency rate (i.e., WACC of country B) =
= 1+Risk Premium of country A / 1+ Rf of country B
Problems:
(1) Taksheel Ltd. is considering a project in Luxemburg, which will involve an
initial investment of GBP 13,000,000. The project will have 5 years of life.
Current spot exchange rate is Rs.58 per GBP. The risk free rate in Germany is
8% and the same in India is 12%. Cash inflow from the project are as follows:
Year
Cash inflow (GBP)
1
3,000,000
2
2,500,000
3
3,500,000
4
4,000,000
5
6,000,000
Calculate the NPV of the project using foreign currency approach. Required rate
of return on this project is 14%.
(2) OJ Ltd. Is a supplier of leather goods to retailers in the UK and other
Western European countries. The company is considering entering into a joint
venture with a manufacturer in South America. The two companies will each own
50 per cent of the limited liability company JV (SA) and will share profits
equally. 450,000 of the initial capital is being provided by OJ Ltd. and the
equivalent in South American dollars (SA$) is being provided by the foreign
partner. The managers of the joint venture expect the following net operating
cash flows, which are in nominal terms:
SA$ 000 Forward Rates of exchange to the Sterling
Year 1 4,250 10
Year 2 6,500 15
Year 3 8,350 21
For tax reasons JV (SV) the company to be formed specifically for the joint
venture, will be registered in South America.
Ignore taxation in your calculations.
Assuming you are financial adviser retained by OJ Limited to advise on the
proposed joint venture.
(i) Calculate the NPV of the project under the two assumptions explained below.
Use a discount rate of 18 per cent for both assumptions.
Assumption 1: The South American country has exchange controls which
prohibit the payment of dividends above 50 per cent of the annual cash flows
for the first three years of the project. The accumulated balance can be
repatriated at the end of the third year.
Assumption 2: The government of the South American country is considering
removing exchange controls and restriction on repatriation of profits. If this
happens all cash flows will be distributed as dividends to the partner companies
at the end of each year.
(ii) Comment briefly on whether or not the joint venture should proceed based
solely on these calculations.
Capital Budgeting Analysis Case:
Wolverine Corp. currently has no existing business in New Zealand but is
considering establishing a subsidiary there. The following information has been
gathered to assess this project:
The initial investment required is $50 million in New Zealand dollars (NZ$).
Given the existing spot rate of $.50 per New Zealand dollar, the initial
investment in U.S. dollars is $25 million. In addition to the NZ$50 million initial
investment for plant and equipment, NZ$20 million is needed for working capital
and will be borrowed by the subsidiary from a New Zealand bank. The New
Zealand subsidiary will pay interest only on the loan each year, at an interest
rate of 14 percent. The loan principal is to be paid in 10 years.
The project will be terminated at the end of Year 3, when the subsidiary will be
sold.
The price, demand, and variable cost of the product in New Zealand are as
follows:
Year
Price
Demand
Variable Cost
1
NZ$500
40,000 units
NZ$30
2
NZ$511
50,000 units
NZ$35
3
NZ$530
60,000 units
NZ$40
The fixed costs, such as overhead expenses, are estimated to be NZ$6
million per year.
The exchange rate of the New Zealand dollar is expected to be $.52 at
the end of Year 1, $.54 at the end of Year 2, and $.56 at the end of Year
3.
The New Zealand government will impose an income tax of 30 percent on
income. In addition, it will impose a withholding tax of 10 percent on
earnings remitted by the subsidiary. The U.S. government will allow a tax
credit on the remitted earnings and will not impose any additional taxes.
All cash flows received by the subsidiary are to be sent to the parent at
the end of each year. The subsidiary will use its working capital to
support ongoing operations.
The plant and equipment are depreciated over 10 years using the
straight-line depreciation method. Since the plant and equipment are
initially valued at NZ$50 million, the annual depreciation expense is NZ$5
million.
In three years, the subsidiary is to be sold. Wolverine plans to let the
acquiring firm assume the existing New Zealand loan. The working capital
will not be liquidated but will be used by the acquiring firm when it sells
the subsidiary. Wolverine expects to receive NZ$52 million after
subtracting capital gains taxes. Assume that this amount is not subject
to a withholding tax.
Wolverine requires a 20 percent rate of return on this project.
REQUIRED:
a. Determine the net present value of this project. Should Wolverine accept
this project?
b. Assume that Wolverine is also considering an alternative financing
arrangement, in which the parent would invest an additional $10 million to
cover the working capital requirements so that the subsidiary would avoid
the New Zealand loan. If this arrangement is used, the selling price of the
subsidiary (after subtracting any capital gains taxes) is expected to be
NZ$18 million higher. Is this alternative financing arrangement more
feasible for the parent than the original proposal? Explain.
c. From the parents perspective, would the NPV of this project be more
sensitive to exchange rate movements if the subsidiary uses New Zealand
financing to cover the working capital or if the parent invests more of its
own funds to cover the working capital? Explain.
d. Assume Wolverine used the original financing proposal and that funds are
blocked until the subsidiary is sold. The funds to be remitted are reinvested
at a rate of 6 percent (after taxes) until the end of Year 3. How is the
projects NPV affected?
e. What is the break-even salvage value of this project if Wolverine uses the
original financing proposal and funds are not blocked?
f. Assume that Wolverine decides to implement the project, using the original
financing proposal. Also assume that after one year, a New Zealand firm
offers Wolverine a price of $27 million after taxes for the subsidiary and
that Wolverines original forecasts for Years 2 and 3 have not changed.
Compare the present value of the expected cash flows it Wolverine keeps
the subsidiary to the selling price. Should Wolverine divest the subsidiary?
Explain.

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Module 4: Multinational Capital Budgeting

Inputs for Multinational Capital Budgeting

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