Global Investment case The Gibson Company is a United

Part A,B

The Gibson Company is a United States (US) firm that is considering a joint venture with Brasilia, DF, a Brazilian firm that grows and processes coffee beans. Gibson has a patent for a new coffee processing method. This intellectual property is motivating Gibson to expand beyond importing coffee to engaging in a joint venture to process the coffee. Gibson will invest $8 million in the proposed joint venture project, which will help to finance Brasilia 's production using the newly patented process.
 

The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at http://www.oanda.com.

For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.
 

The expected total profits resulting from the joint venture per year are as follows:
 

Gibson's average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibson’s US income tax rate is 10 percent. Gibson’s capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates.

Gibson is concerned about country risk in the following two forms:

(1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs, Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this joint venture.

(2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson (20 percent probability)? If this occurs, Gibson will not receive additional tax credits, and the company will still be subject to US tax on the profits from this joint venture.

Assume that the two types of country risk are mutually exclusive. If it does anything, the Brazilian government will only implement one of these changes in its tax policies (i.e., the increase in the basic income tax on the profits of the joint venture or the additional income tax on profits distributed to foreign companies). The Brazilian government may also choose to leave things as they are.

Assignment 

1. Determine Gibson's cost of capital and required rate of return for the joint venture in Brazil.

WACC = Proportion of debt * pre tax Cost of debt * (1- Tax rate) + proportion of equity * post tax cost of equity

=70%*6%*(1-7%) + 30%*9%

=6.61%

Required rate of return from Joint Venture in Brasilia = WACC + risk premium for international JV’s

=Between 6.61% + 2.00% =8.61% to 6.61% + 5.00% =11.61% 

Thus, the required rate of return is between 8.61% to 11.61% depending on where the company classifies Brazil within the international risk scenario. Assuming an average level of risk, we can take an average of the range and set the required rate of return to 10.11%

1. Determine the discrete probability distribution of Gibson's Net Present Value for this joint venture and calculate the Expected Net Present Value.

Scenario 1:Based on original assumptions

Scenario 2:Based on an increase in the corporate income tax by the Brazilian government

Scenario 3: Based on the imposition of a withholding tax by the Brazilian government

Thus, the probability distribution for the NPV is as follows:

NPV                 Probability

31.74 million      0.20

34.77 million      0.20

39.52 million      0.60

3. Would you recommend that Gibson participate in the joint venture? Explain.

The expected NPV for the JV = 0.20*31.74+0.20*34.77+0.60*39.52 = 37.014 million

Since the expected NPV is positive, Gibson should participate in the joint venture (JV).

4. What do you think would be the key underlying factor that would have the most influence on the profits earned in Brazil as a result of the joint venture?

The major factor is the threat of increase in corporate tax as it results in maximum loss in NPV.

Even with this threat; however, the JV will be a profitable option.

5. Under what circumstances might Gibson shift to more equity financing when considering joint ventures like this? What is the minimum required return that would still make this investment worthwhile?

If the payoffs from the JV have high variance, Gibson should seek more equity investment to protect against default in debt payment.

The minimum rate of return that would make this JV viable will depend upon the capital structure. If we add more debt, the required rate of return will decline. At the minimum required rate of return the expected NPV would become zero. However, here we have assumed that the cost of debt and equity would remain the same when we change the capital structure, which may not be true. If the cost of debt and equity increase as we increase the level of debt in the capital structure, it will not make any sense to change the capital structure.

At current capital structure, the minimum required rate of return is 10.11%.

6. When Gibson was assessing this proposed joint venture, some of the managers in the company recommended that it borrow the Brazilian currency rather than using US dollars to obtain some of the necessary capital for the initial investment. They suggested that such a strategy could reduce Gibson’s exchange rate risk. Do you agree? Explain.

Since JV’s investment and returns are in BRL, by borrowing in BRL, there is no currency risk associated with the interest and loan repayment. Thus, the exchange risk with regard to the loan payments will be reduced. However, Gibson still need to convert its profits into $ to bring them into US so the risk related to the transfer of profit would still remain. Thus, exchange risk will reduce but it will still be there.

7. Discuss the benefits of the joint venture from the perspective of Brasilia. What is the maximum amount of money Brasilia should invest? 

The benefits of the joint venture to the Brasilia:

§  60% profits for the first five years

§  Full profits after the first five years

§  Acquisition of new coffee processing method (know how transfer)

§  Investment by Gibson will enable Brasilia access to low cost funds (the cost of funds to Gibson is most likely less than that for the Brasilia)

Maximum amount that Brasilia can invest will depend upon the cost of capital to the Brasilia.  Also, we do not know what the profits are after the first five years. Hence, the data is insufficient to calculate this value.

The method is:

Calculate the post tax cash flows to Brasilia (60% of profits for first five years and 100% thereafter, less tax in Brazil).   Discount the cash flows with required rate of return and get the maximum amount which can be invested.