International finance
pizzaman
hw_3_2.xlsx1
| Problem 18.1 Natural Mosaic | |||||||
| Natural Mosaic Company (U.S.) is considering investing Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years the subsidiary would be sold to Indian investors for Rs100,000,000. A pro forma income statement for the Indian operation predicts the generation of Rs7,000,000 of annual cash flow, is listed below. | |||||||
| The initial investment will be made on December 31, 2011, and cash flows will occur on December 31 of each succeeding year. Annual cash dividends to Philadelphia Composite from India will equal 75% of accounting income. | |||||||
| The U.S. corporate tax rate is 40% and the Indian corporate tax rate is 50%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Natural Mosaic will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Natural Mosaic uses a weighted average cost of capital of 14% on domestic investments, but will add 6 percentage points for the Indian investment because of perceived greater risk. Natural Mosaic forecasts the rupee/dollar exchange rate for December 31 on the next six years are listed below. | |||||||
| What is the net present value and internal rate of return on this investment? | |||||||
| Assumptions | Values | Assumptions | Values | ||||
| Initial investment in India (Rs) | 50,000,000 | Dividend distribution per year | 75.00% | ||||
| Indian corporate tax rate | 50.00% | US corporate tax rate | 40.00% | ||||
| Sale price in year 5 (Rs) | 100,000,000 | India risk premium to WACC | 6.00% | ||||
| Natural Mosaic's WACC | 14.00% | ||||||
| Pro forma income and cash flow | 0 | 1 | 2 | 3 | 4 | 5 | |
| (December 31st) | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
| Sales revenue | 30,000,000 | 30,000,000 | 30,000,000 | 30,000,000 | 30,000,000 | ||
| Less cash operating expenses | (17,000,000) | (17,000,000) | (17,000,000) | (17,000,000) | (17,000,000) | ||
| Gross income | 13,000,000 | 13,000,000 | 13,000,000 | 13,000,000 | 13,000,000 | ||
| Less depreciation expenses | (1,000,000) | (1,000,000) | (1,000,000) | (1,000,000) | (1,000,000) | ||
| Earnings before interest and taxes | 12,000,000 | 12,000,000 | 12,000,000 | 12,000,000 | 12,000,000 | ||
| Less Indian taxes at 50% | (6,000,000) | (6,000,000) | (6,000,000) | (6,000,000) | (6,000,000) | ||
| Net income | 6,000,000 | 6,000,000 | 6,000,000 | 6,000,000 | 6,000,000 | ||
| Add back depreciation | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | ||
| Annual cash flow | 7,000,000 | 7,000,000 | 7,000,000 | 7,000,000 | 7,000,000 | ||
| Initial investment | (50,000,000) | ||||||
| Terminal value, sales | 100,000,000 | ||||||
| Cash flows for discounting | (50,000,000) | 7,000,000 | 7,000,000 | 7,000,000 | 7,000,000 | 107,000,000 | |
| Present value factor | 20% | 1.0000 | 0.8333 | 0.6944 | 0.5787 | 0.4823 | 0.4019 |
| Present value of cash flow | (50,000,000) | 5,833,333 | 4,861,111 | 4,050,926 | 3,375,772 | 43,000,900 | |
| NPV of India investment (project view) | 11,122,042 | ||||||
| IRR of Indian investment (project view) | 25.96% | ||||||
| Cash inflows & outflows to US | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | |
| Initial investment (Rs) | (50,000,000) | ||||||
| Dividends received in the US (Rs) | 4,500,000 | 4,500,000 | 4,500,000 | 4,500,000 | 4,500,000 | ||
| Sales value (Rs) | 100,000,000 | ||||||
| Net cash flows to parent after-tax (Rs) | (50,000,000) | 4,500,000 | 4,500,000 | 4,500,000 | 4,500,000 | 104,500,000 | |
| Expected exchange rate (Rs/$) | 50.00 | 54.00 | 58.00 | 62.00 | 66.00 | 70.00 | |
| Net cash flows to parent after-tax (US$) | $ (1,000,000) | $ 83,333 | $ 77,586 | $ 72,581 | $ 68,182 | $ 1,492,857 | |
| Present value factor | 20% | 1.0000 | 0.8333 | 0.6944 | 0.5787 | 0.4823 | 0.4019 |
| Present value of cash flow | (1,000,000) | 69,444 | 53,879 | 42,003 | 32,881 | 599,946 | |
| NPV of cash flows (parent viewpoint) | (201,847) | ||||||
| IRR of cash flows (parent viewpoint) | 13.94% | ||||||
Pbm18.2
| Problem 18.2 Grenouille Properties | |||||
| Grenouille Properties (U.S.) expects to receive cash dividends from a French joint venture over the coming three years. The first dividend , to be paid December 31, 2011, is expected to be €720,000. The dividend is then expected to grow 10.0% per year over the following two years. The current exchange rate (December 30, 2010) is $1.3603/€. Grenouille’s weighted average cost of capital is 12%. | |||||
| a. What is the present value of the expected euro dividend stream if the euro is expected to appreciate 4.00% per annum against the dollar? | |||||
| b. What is the present value of the expected dividend stream if the euro were to depreciate 3.00% per annum against the dollar? | |||||
| Assumptions | Values | ||||
| Cash dividends to be received (euros) | € 720,000 | ||||
| Expected dividend growth rate per year | 10.0% | ||||
| Current spot exchange rate ($/euro) | $ 1.3603 | ||||
| Grenouille's weighted average cost of capital | 12.0% | ||||
| a) PV of dividend stream if euro appreciates 4% | 0 | 1 | 2 | 3 | |
| Dividend stream expected from investment, in euros | € 720,000 | € 792,000 | € 871,200 | ||
| Current and expected spot rate ($/euro) : spot x ( 1 + .04) | 4.0% | $ 1.3603 | $ 1.4147 | $ 1.4713 | $ 1.5302 |
| Dividends, in US dollars | $ 1,018,593 | $ 1,165,270 | $ 1,333,069 | ||
| Present value factor | 1.0000 | 0.8929 | 0.7972 | 0.7118 | |
| Present value of dividends, in US dollars | $ 909,458 | $ 928,946 | $ 948,852 | ||
| Cumulative NPV | $ 2,787,256 | ||||
| b) PV of dividend stream if euro depreciates 3% | 0 | 1 | 2 | 3 | |
| Dividend stream expected from investment, in euros | € 720,000 | € 792,000 | € 871,200 | ||
| Current and expected spot rate ($/euro) : spot x ( 1 - .03) | -3.0% | $ 1.3603 | $ 1.3195 | $ 1.2799 | $ 1.2415 |
| Dividends, in US dollars | $ 950,034 | $ 1,013,686 | $ 1,081,603 | ||
| Present value factor | 1.0000 | 0.8929 | 0.7972 | 0.7118 | |
| Present value of dividends in US dollars | $ 848,244 | $ 808,104 | $ 769,863 | ||
| Cumulative NPV | $ 2,426,212 | ||||
Pbm18.3
| Problem 18.3 Carambola de Honduras | ||||
| Slinger Wayne, a U.S.-based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 13 million Honduran lempiras (Lp) next year (2012), and that this free cash flow will continue to grow at a constant rate of 8.0% per annum indefinitely | ||||
| A private equity firm like Slinger Wayne, however, is not interested in owning a company for long, and plans to sell Carambola at the end of three years for approximately 10 times Carambola’s free cash flow in that year. The current spot exchange rate is Lp14.80/$, but the Honduran inflation rate is expected to remain at a relatively high rate of 16.0% per annum compared to the U.S. dollar inflation rate of only 2.0% per annum. Slinger Wayne expects to earn at least a 20% annual rate of return on international investments like Carambola. | ||||
| a. What is Carambola worth if the Honduran lempira were to remain fixed over the three year investment period? | ||||
| b. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity? | ||||
| Assumptions | Values | |||
| Expected free cash flow in 2003 | 13,000,000 | |||
| Expected growth rate in free cash flow | 8.00% | |||
| Assumed sale multiple of FCF in year 3 | 10 | |||
| Spot exchange rate, Lempiras/$ (2002) | 14.80 | |||
| US dollar inflation rate | 2.0% | |||
| Honduran lempira inflation rate | 16.0% | |||
| Slinger Wayne required return (annual rate) | 20.0% | |||
| 0 | 1 | 2 | 3 | |
| a) Carambola's value if exchange rate fixed | 2012 | 2013 | 2014 | 2015 |
| Carambola's expected free cash flow (Lp) | 13,000,000 | 14,040,000 | 15,163,200 | |
| Expected sale value in year 3 | 151,632,000 | |||
| Total expected free cash flow (Lp) | 13,000,000 | 14,040,000 | 166,795,200 | |
| Expected exchange rate (Lp/$) | 14.8000 | 14.8000 | 14.8000 | 14.8000 |
| Carambola's expected FCF in US$ | $ 878,378 | $ 948,649 | $ 11,269,946 | |
| Present value factor | 1.0000 | 0.8333 | 0.6944 | 0.5787 |
| Present value of expected FCF in US$ | $ 731,982 | $ 658,784 | $ 6,521,959 | |
| Cumulative present value in US$ | $ 7,912,725 | |||
| 0 | 1 | 2 | 3 | |
| b) Carambola's value assuming PPP | 2012 | 2013 | 2014 | 2015 |
| Carambola's expected free cash flow (Lp) | 13,000,000 | 14,040,000 | 15,163,200 | |
| Expected sale value in year 3 | 151,632,000 | |||
| Total expected free cash flow (Lp) | 13,000,000 | 14,040,000 | 166,795,200 | |
| Expected exchange rate (Lp/$) | 14.8000 | 16.8314 | 19.1416 | 21.7688 |
| (PPP: spot * (1+inf in Lp) / (1 + inf in $) | ||||
| Carambola's expected FCF in US$ | $ 772,367 | $ 733,483 | $ 7,662,110 | |
| Present value factor | 1.0000 | 0.8333 | 0.6944 | 0.5787 |
| Present value of expected FCF in US$ | $ 643,639 | $ 509,363 | $ 4,434,091 | |
| Cumulative present value in US$ | $ 5,587,094 | |||
Pbm18.4
| Problem 18.4 Finisterra, S.A. | ||||
| Finisterra, S.A., located in the state of Baja California, Mexico, manufactures frozen Mexican food which enjoys a large following in the U.S. states of California and Arizona to the north. In order to be closer to its U.S. market, Finisterra is considering moving some of its manufacturing operations to southern California. Operations in California would begin in Year 1 and have the attributes listed below. The | ||||
| peso/dollar exchange rate (Ps/$) is expected to be 8.00 (Year 0), 9.00 (Year 1), 10.00 (Year 2) and 11.00 (Year 3). | ||||
| The operations in California will pay 80% of its accounting profit to Finisterra as an annual cash dividend. Mexican taxes are calculated on grossed up dividends from foreign countries, with a credit for host country taxes already paid. What is the maximum U.S. dollar price Finisterra should offer in Year 1 for the investment? | ||||
| Assumptions | Value | |||
| Sales price per unit, Year 1 (US$) | $ 5.00 | |||
| Sales price increase, per year | 3.00% | |||
| Initial sales volume, Year 1, units | 1,000,000 | |||
| Sales volume increase, per year | 10.00% | |||
| Production costs per unit, Year 1 | $ 4.00 | |||
| Production cost per unit increase, per year | 4.00% | |||
| General and administrative expenses per year | $ 100,000 | |||
| Depreciation expenses per year | $ 80,000 | |||
| Finisterra's WACC (pesos) | 16.00% | |||
| Terminal value discount rate | 20.00% | |||
| Capital Budgeting Analysis | Year 0 | Year 1 | Year 2 | Year 3 |
| Sales price, US$ | $ 5.00 | $ 5.15 | $ 5.30 | |
| Sales volume | 1,000,000 | 1,100,000 | 1,210,000 | |
| Revenue | $ 5,000,000 | $ 5,665,000 | $ 6,418,445 | |
| Costs per package | $ (4.00) | $ (4.16) | $ (4.33) | |
| Total costs | (4,000,000) | (4,576,000) | (5,234,944) | |
| Gross profit | $ 1,000,000 | $ 1,089,000 | $ 1,183,501 | |
| Less general & administration expenses | (100,000) | (100,000) | (100,000) | |
| Less depreciation expenses | (80,000) | (80,000) | (80,000) | |
| Operating profit before tax | $ 820,000 | $ 909,000 | $ 1,003,501 | |
| Less U.S. corporate income taxes | 30% | (246,000) | (272,700) | (301,050) |
| Net income | $ 574,000 | $ 636,300 | $ 702,451 | |
| Dividends distributed ($) | 80% | $ 459,200 | $ 509,040 | $ 561,961 |
| (80% of net income) | ||||
| Exchange rate (Ps/$) | 8.00 | 9.00 | 10.00 | 11.00 |
| Dividends remitted to parent (pesos) | 4,132,800 | 5,090,400 | 6,181,566 | |
| Additional taxes due in Mexico | 0 | 0 | 0 | |
| Dividend received, after-tax (pesos) | 4,132,800 | 5,090,400 | 6,181,566 | |
| Terminal value, US$ (discounted @ 20%) | $ 2,809,803 | |||
| (dividend in Year 3/.20) | ||||
| Terminal value, pesos | 30,907,831 | |||
| Total cash flows for discounting (pesos) | 4,132,800 | 5,090,400 | 37,089,397 | |
| Present value factor (@ 16%) | 1.0000 | 0.8333 | 0.6944 | 0.5787 |
| Present value of total cash flows (pesos) | 3,444,000 | 3,535,000 | 21,463,771 | |
| Cumulative present value (pesos) | 28,442,771 | |||
| in US dollars | $ 3,555,346 | |||
Pbm18.5
| Problem 18.5 Doohicky Devices | |||||||
| Doohicky Devices, Inc., manufactures design components for personal computers. Until the present, manufacturing has been subcontracted to other companies, but for reasons of quality control Doohicky has decided to manufacture itself in Asia. Analysis has narrowed the choice to two possibilities, Penang, Malaysia, and Manila, the Philippines. At the moment only the following summary of expected, after tax, cash flows is available. Although most operating outflows would be in Malaysian ringgit or Philippine pesos, some additional U.S. dollar cash outflows would be necessary, as shown in the table below. | |||||||
| The Malaysia ringgit currently trades at RM3.80/$ and the Philippine peso trades at Ps50.00/$. Doohicky expects the Malaysian ringgit to appreciate 2.0% per year against the dollar, and the Philippine peso to depreciate 5.0% per year against the dollar. If the weighted average cost of capital for Doohicky Devices is 14.0%, which project looks most promising? | |||||||
| Assumptions | Values | ||||||
| Current spot rate (ringgit/$) | 3.80 | ||||||
| Current spot rate (pesos/$) | 50.00 | ||||||
| Malaysian ringgit expectation (% change) | 2.000% | ||||||
| Phillippine peso expectation (% change) | -5.000% | ||||||
| WACC for Doohicky Devices | 14.000% | ||||||
| 0 | 1 | 2 | 3 | 4 | 5 | ||
| Doohicky in Penang (after-tax) | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
| Net ringgit cash flows | (26,000) | 8,000 | 6,800 | 7,400 | 9,200 | 10,000 | |
| Expected exchange rate (ringgit/$) | 3.8000 | 3.7255 | 3.6524 | 3.5808 | 3.5106 | 3.4418 | |
| (spot / (1+.02)) | |||||||
| Ringgit cash flows in dollars | $ (6,842) | $ 2,147 | $ 1,862 | $ 2,067 | $ 2,621 | $ 2,905 | |
| Dollar cash outflows | - 0 | (100) | (120) | (150) | (150) | - 0 | |
| Net total cash flows (US$) | $ (6,842) | $ 2,047 | $ 1,742 | $ 1,917 | $ 2,471 | $ 2,905 | |
| Present value factor | 14% | 1.0000 | 0.8772 | 0.7695 | 0.6750 | 0.5921 | 0.5194 |
| Present value of cash flow | $ (6,842) | $ 1,796 | $ 1,340 | $ 1,294 | $ 1,463 | $ 1,509 | |
| Net present value (NPV) | $ 560 | ||||||
| 0 | 1 | 2 | 3 | 4 | 5 | ||
| Doohicky in Manila (after-tax) | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
| Net peso cashflows | (560,000) | 190,000 | 180,000 | 200,000 | 210,000 | 200,000 | |
| Expected exchange rate (pesos/$) | 50.00 | 52.63 | 55.40 | 58.32 | 61.39 | 64.62 | |
| (spot / ( 1 - .05)) | |||||||
| Net peso cashflows in dollars | $ (11,200) | $ 3,610 | $ 3,249 | $ 3,429 | $ 3,421 | $ 3,095 | |
| Dollar cash outflows | (100) | (200) | (300) | (400) | - 0 | ||
| Net dollar cashflows, total | $ (11,200) | $ 3,510 | $ 3,049 | $ 3,129 | $ 3,021 | $ 3,095 | |
| Present value factor | 14% | 1.0000 | 0.8772 | 0.7695 | 0.6750 | 0.5921 | 0.5194 |
| Present value of cash flow | $ (11,200) | $ 3,079 | $ 2,346 | $ 2,112 | $ 1,789 | $ 1,608 | |
| Net present value (NPV) | $ (266) | ||||||
| Neither project looks very promising. Doohicky Penang does, however, possess a positive NPV. | |||||||
Pbm18.6
| Problem 18.6 Wenceslas Refining Company | |||||
| Privately owned Wenceslas Refining Company is considering investing in the Czech Republic so as to have a refinery source closer to its European customers. The original investment in Czech korunas would amount to K250 million, or $5,000,000 at the current spot rate of K32.50/$, all in fixed assets, which will be depreciated over ten years by the straight-line method. An additional K100,000,000 will be needed for working capital. | |||||
| For capital budgeting purposes Wenceslas assumes sale as a going concern at the end of the third year at a price, after all taxes, equal to the net book value of fixed assets alone (not including working capital). All free cash flow will be repatriated to the United States as soon as possible. In evaluating the venture, the U.S. dollar forecasts are shown in the table below. | |||||
| Variable manufacturing costs are expected to be 50% of sales. No additional funds need be invested in the U.S. subsidiary during the period under consideration. The Czech Republic imposes no restrictions on repatriation of any funds of any sort. The Czech corporate tax rate is 25% and the United States rate is 40%. Both countries allow a tax credit for taxes paid in other countries. Wenceslas uses 18% as its weighted average cost of capital, and its objective is to maximize present value. Is the investment attractive to Wenceslas Refining? | |||||
| Assumptions | 0 | 1 | 2 | 3 | |
| Original investment (Czech korunas, K) | 250,000,000 | ||||
| Spot exchange rate (K/$) | 32.50 | 30.00 | 27.50 | 25.00 | |
| Unit demand | 700,000 | 900,000 | 1,000,000 | ||
| Unit sales price | $ 10.00 | $ 10.30 | $ 10.60 | ||
| Fixed cash operating expenses | $ 1,000,000 | $ 1,030,000 | $ 1,060,000 | ||
| Depreciation | $ 500,000 | $ 500,000 | $ 500,000 | ||
| Investment in working capital (K) | 100,000,000 | ||||
| Project Viewpoint (in US$) | 0 | 1 | 2 | 3 | |
| Initial investment | $ (7,692,308) | ||||
| Revenues | $ 7,000,000 | $ 9,270,000 | $ 10,600,000 | ||
| Less costs of manufacturing | 50% | (3,500,000) | (4,635,000) | (5,300,000) | |
| Gross profit | $ 3,500,000 | $ 4,635,000 | $ 5,300,000 | ||
| Less fixed cash operating expenses | (1,000,000) | (1,030,000) | (1,060,000) | ||
| Less depreciation | 10.0 | (769,231) | (769,231) | (769,231) | |
| Earnings before taxes | $ 1,730,769 | $ 2,835,769 | $ 3,470,769 | ||
| Less Czech corporate income taxes | 25% | (432,692) | (708,942) | (867,692) | |
| Net income | $ 1,298,077 | $ 2,126,827 | $ 2,603,077 | ||
| Add back depreciation | 769,231 | 769,231 | 769,231 | ||
| Less additional working capital investment | $ (3,076,923) | ||||
| Sale value | 8,461,538 | ||||
| Free cash flow for discounting | $ (10,769,231) | $ 2,067,308 | $ 2,896,058 | $ 11,833,846 | |
| Present value factor | 18% | 1.0000 | 0.8475 | 0.7182 | 0.6086 |
| Present value of cash flows | $ (10,769,231) | $ 1,751,956 | $ 2,079,904 | $ 7,202,444 | |
| Cumulative NPV | $ 265,073 | ||||
| Parent Viewpoint (US$) | 0 | 1 | 2 | 3 | |
| Dividends remitted to US parent | $ 1,298,077 | $ 2,126,827 | $ 2,603,077 | ||
| Add back Czech taxes deemed paid | 432,692 | 708,942 | 867,692 | ||
| Grossed up dividend | $ 1,730,769 | $ 2,835,769 | $ 3,470,769 | ||
| Tentative US tax liability | 40% | $ 692,308 | $ 1,134,308 | $ 1,388,308 | |
| Less credit for Czech taxes paid | (432,692) | (708,942) | (867,692) | ||
| Additional US taxes due on foreign income | $ 259,615 | $ 425,365 | $ 520,615 | ||
| Cash dividend less added US taxes | $ 1,038,462 | $ 1,701,462 | $ 2,082,462 | ||
| Initial investment & working capital | $ (10,769,231) | ||||
| Plus sale value at end of 3 years | 8,461,538 | ||||
| Parent cash flows (US$) | $ (10,769,231) | $ 1,038,462 | $ 1,701,462 | $ 10,544,000 | |
| Present value factor | 18% | 1.0000 | 0.8475 | 0.7182 | 0.6086 |
| Present value of cash flow | $ (10,769,231) | $ 880,052 | $ 1,221,963 | $ 6,417,404 | |
| Cumulative NPV | $ (2,249,812) | ||||
Pbm18.7
| Problem 18.7 Hermosa Components: Baseline Analysis | ||||||
| Use the following information and assumptions to answer problems 7-10. Hermosa Beach Components, Inc., of California exports 24,000 sets of low-density light bulbs per year to Argentina under an import license that expires in five years. In Argentina the bulbs are sold for the Argentine peso equivalent of $60 per set. Direct manufacturing costs in the United States and shipping together amount to $40 per set. The market for this type of bulb in Argentina is stable, neither growing nor shrinking, and Hermosa holds the major portion of the market. | ||||||
| The Argentine government has invited Hermosa to open a manufacturing plant so imported bulbs can be replaced by local production. If Hermosa makes the investment, it will operate the plant for five years and then sell the building and equipment to Argentine investors at net book value at the time of sale plus the value of any net working capital. (Net working capital is the amount of current assets less any portion financed by local debt.) Hermosa will be allowed to repatriate all net income and depreciation funds to the United States each year. Hermosa traditionally evaluates all foreign investments in U.S. dollar terms. | ||||||
| Evaluate the proposed investment in Argentina by Hermosa Components (US). Hermosa’s management wishes the baseline analysis to be performed in U.S. dollars (and implicitly also assumes the exchange rate remains fixed throughout the life of the project). Create a project viewpoint capital budget and a parent viewpoint capital budget. What do you conclude from your analysis? | ||||||
| Assumptions | Value | Growth | ||||
| Light bulb export volume to Argentina, per year | 24,000 | 0.00% | ||||
| Sales price per set in Argentina | $ 60.00 | 0.00% | ||||
| Material costs per set in Argentina | $ 20.00 | 0.00% | ||||
| Material and shipping costs of imports per set | $ 10.00 | 0.00% | ||||
| Direct & indirect cost per set | $ 5.00 | 0.00% | ||||
| Depreciable investment (buildings & equipment) | $ 1,000,000 | |||||
| Initial investment in net working capital | $ 1,000,000 | |||||
| Discount rate in Argentina | 15.00% | |||||
| Project Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Year | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
| The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint). | ||||||
| Project Cash Flows in Argentina: Project Viewpoint | ||||||
| Annual units sold (sets) | 24,000 | 24,000 | 24,000 | 24,000 | 24,000 | |
| Sales price in Argentina per set | $ 60.00 | $ 60.00 | $ 60.00 | $ 60.00 | $ 60.00 | |
| Sales revenue | $ 1,440,000 | $ 1,440,000 | $ 1,440,000 | $ 1,440,000 | $ 1,440,000 | |
| Less direct manufacturing and shipping costs | (480,000) | (480,000) | (480,000) | (480,000) | (480,000) | |
| Less cost of US components @ $10/set | (240,000) | (240,000) | (240,000) | (240,000) | (240,000) | |
| Gross profit | 720,000 | 720,000 | 720,000 | 720,000 | 720,000 | |
| Less depreciation | (200,000) | (200,000) | (200,000) | (200,000) | (200,000) | |
| Pre-tax profit | 520,000 | 520,000 | 520,000 | 520,000 | 520,000 | |
| Less 40% Argentine taxes | 40% | (208,000) | (208,000) | (208,000) | (208,000) | (208,000) |
| Net income | 312,000 | 312,000 | 312,000 | 312,000 | 312,000 | |
| Add back depreciation | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | |
| Annual project cash flow | 512,000 | 512,000 | 512,000 | 512,000 | 512,000 | |
| Return of net working capital | 1,000,000 | |||||
| Initial investment, total | (2,000,000) | |||||
| Free cash flow for discounting | $ (2,000,000) | $ 512,000 | $ 512,000 | $ 512,000 | $ 512,000 | $ 1,512,000 |
| Internal rate of return (IRR) | 18.7% | |||||
| Net present value (NPV) | $ 213,480 | |||||
| The Parent Viewpoint needs to consider all incremental cash flow impacts including loss on export sales to Argentina (current practice). | ||||||
| Cash Flows to Hermosa in US: Parent Viewpoint | ||||||
| Sales revenue on exports to Argentina | $ 240,000 | $ 240,000 | $ 240,000 | $ 240,000 | $ 240,000 | |
| Less direct and indirect costs on exported sets | (120,000) | (120,000) | (120,000) | (120,000) | (120,000) | |
| Profit on Hermosa's component sales | $ 120,000 | $ 120,000 | $ 120,000 | $ 120,000 | $ 120,000 | |
| Less US taxes on component profits @ 40% | 40% | (48,000) | (48,000) | (48,000) | (48,000) | (48,000) |
| a) Net profit on component sales after-tax | $ 72,000 | $ 72,000 | $ 72,000 | $ 72,000 | $ 72,000 | |
| b) Cash flow from Argentina to Hermosa (US) | 512,000 | 512,000 | 512,000 | 512,000 | 512,000 | |
| Cash flow loss on Hermosa's loss of exports | (480,000) | (480,000) | (480,000) | (480,000) | (480,000) | |
| Less US taxes on export losses | 40% | 192,000 | 192,000 | 192,000 | 192,000 | 192,000 |
| c) Net cash flow reduction after-tax | $ (288,000) | $ (288,000) | $ (288,000) | $ (288,000) | $ (288,000) | |
| d) Recapture of NWC in Argentina (no tax) | $ 1,000,000 | |||||
| Total parent cash flow, after-tax (a+b+c+d) | 296,000 | 296,000 | 296,000 | 296,000 | 1,296,000 | |
| Initial investment | (2,000,000) | |||||
| Free cash flow to parent for discounting | $ (2,000,000) | $ 296,000 | $ 296,000 | $ 296,000 | $ 296,000 | $ 1,296,000 |
| Internal rate of return (IRR) | 5.9% | |||||
| Net present value (NPV) | $ (510,585) | |||||
| Although the investment has a positive NPV on the project level, the prospective investment from the parent's viewpoint is negative. | ||||||
| The project as described should be rejected. | ||||||
Pbm18.8
| Problem 18.8 Hermosa Components: Revenue Growth Scenario | ||||||
| As a result of their analysis in the previous question, Hermosa wishes to explore the implications of being able to grow sales volume by 4% per year. Argentine inflation is expected to average 5% per year, so sales price and material cost increases of 7% and 6% per year, respectively, are thought reasonable. Although material costs in Argentina are expected to rise, US-based costs are not expected to change over the 5-year period. Evaluate this scenario for both the project and parent viewpoints. Is the project under this revenue growth scenario acceptable? | ||||||
| Assumptions | Value | Growth | ||||
| Light bulb export volume to Argentina, per year | 24,000 | 4.00% | ||||
| Sales price per set in Argentina | $ 60.00 | 7.00% | ||||
| Material costs per set in Argentina | $ 20.00 | 6.00% | ||||
| Material and shipping costs of imports per set | $ 10.00 | 0.00% | ||||
| Direct & indirect cost per set | $ 5.00 | 0.00% | ||||
| Depreciable investment (buildings & equipment) | $ 1,000,000 | |||||
| Initial investment in net working capital | $ 1,000,000 | |||||
| Discount rate in Argentina | 15.00% | |||||
| Project Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Year | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
| The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint). | ||||||
| Project Cash Flows in Argentina: Project Viewpoint | ||||||
| Annual units sold (sets) | 24,000 | 24,960 | 25,958 | 26,997 | 28,077 | |
| Sales price in Argentina per set | $ 60.00 | $ 64.20 | $ 68.69 | $ 73.50 | $ 78.65 | |
| Sales revenue | $ 1,440,000 | $ 1,602,432 | $ 1,783,186 | $ 1,984,330 | $ 2,208,162 | |
| Less direct manufacturing and shipping costs | (480,000) | (529,152) | (583,337) | (643,071) | (708,921) | |
| Less cost of US components @ $10/set | (240,000) | (249,600) | (259,584) | (269,967) | (280,766) | |
| Gross profit | 720,000 | 823,680 | 940,265 | 1,071,291 | 1,218,475 | |
| Less depreciation | (200,000) | (200,000) | (200,000) | (200,000) | (200,000) | |
| Pre-tax profit | 520,000 | 623,680 | 740,265 | 871,291 | 1,018,475 | |
| Less 40% Argentine taxes | 40% | (208,000) | (249,472) | (296,106) | (348,517) | (407,390) |
| Net income | 312,000 | 374,208 | 444,159 | 522,775 | 611,085 | |
| Add back depreciation | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | |
| Annual project cash flow | 512,000 | 574,208 | 644,159 | 722,775 | 811,085 | |
| Return of net working capital | 1,000,000 | |||||
| Initial investment, total | (2,000,000) | |||||
| Free cash flow for discounting | (2,000,000) | 512,000 | 574,208 | 644,159 | 722,775 | 1,811,085 |
| Internal rate of return (IRR) | 24.9% | |||||
| Net present value (NPV) | $ 616,624 | |||||
| The Parent Viewpoint needs to consider all incremental cash flow impacts, including loss on export sales to Argentina (current practice). | ||||||
| Cash Flows to Hermosa in US: Parent Viewpoint | ||||||
| Sales revenue on exports to Argentina | $ 240,000 | $ 249,600 | $ 259,584 | $ 269,967 | $ 280,766 | |
| Less direct and indirect costs on exported sets | (120,000) | (124,800) | (129,792) | (134,984) | (140,383) | |
| Profit on Hermosa's component sales | $ 120,000 | $ 124,800 | $ 129,792 | $ 134,984 | $ 140,383 | |
| Less US taxes on component profits @ 40% | 40% | (48,000) | (49,920) | (51,917) | (53,993) | (56,153) |
| a) Net profit on component sales after-tax | $ 72,000 | $ 74,880 | $ 77,875 | $ 80,990 | $ 84,230 | |
| b) Cash flow from Argentina to Hermosa (US) | $ 512,000 | $ 574,208 | $ 644,159 | $ 722,775 | $ 811,085 | |
| Cash flow loss on Hermosa's loss of exports | (480,000) | (499,200) | (519,168) | (539,935) | (561,532) | |
| Less US taxes on export losses | 40% | 192,000 | 199,680 | 207,667 | 215,974 | 224,613 |
| c) Net cash flow reduction after-tax | $ (288,000) | $ (299,520) | $ (311,501) | $ (323,961) | $ (336,919) | |
| d) Recapture of NWC in Argentina (no tax) | $ 1,000,000 | |||||
| Total parent cash flow, after-tax (a+b+c+d) | 296,000 | 349,568 | 410,533 | 479,804 | 1,558,395 | |
| Initial investment | (2,000,000) | |||||
| Free cash flow to parent for discounting | $ (2,000,000) | $ 296,000 | $ 349,568 | $ 410,533 | $ 479,804 | $ 1,558,395 |
| Internal rate of return (IRR) | 12.4% | |||||
| Net present value (NPV) | $ (159,225) | |||||
| Although the investment has a positive NPV on the project level, the prospective investment from the parent's viewpoint is negative. | ||||||
| The project as described should be rejected. | ||||||
Pbm18.9
| Problem 18.9 Hermosa Components: Revenue Growth and Sales Price Scenario | ||||||
| In addition to the assumptions employed in problem 8, Hermosa now wishes to evaluate the prospect of being able to sell the Argentine subsidiary at the end of year 5 at a multiple of the business’s earnings in that year. Hermosa believes that a multiple of 6 is a conservative estimate of the market value of the firm at that time. Evaluate the project and parent viewpoint capital budgets. | ||||||
| Assumptions | Value | Growth | Assumptions | Value | ||
| Light bulb export volume to Argentina, per year | 24,000 | 4.00% | Sales multiple in year 5 | 6.00 | ||
| Sales price per set in Argentina | $ 60.00 | 7.00% | ||||
| Material costs per set in Argentina | $ 20.00 | 6.00% | ||||
| Material and shipping costs of imports per set | $ 10.00 | 0.00% | ||||
| Direct & indirect cost per set | $ 5.00 | 0.00% | ||||
| Depreciable investment (buildings & equipment) | $ 1,000,000 | |||||
| Initial investment in net working capital | $ 1,000,000 | |||||
| Discount rate in Argentina | 15.00% | |||||
| Project Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Year | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
| The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint). | ||||||
| Project Cash Flows in Argentina: Project Viewpoint | ||||||
| Annual units sold (sets) | 24,000 | 24,960 | 25,958 | 26,997 | 28,077 | |
| Sales price in Argentina per set | $ 60.00 | $ 64.20 | $ 68.69 | $ 73.50 | $ 78.65 | |
| Sales revenue | $ 1,440,000 | $ 1,602,432 | $ 1,783,186 | $ 1,984,330 | $ 2,208,162 | |
| Less direct manufacturing and shipping costs | (480,000) | (529,152) | (583,337) | (643,071) | (708,921) | |
| Less cost of US components @ $10/set | (240,000) | (249,600) | (259,584) | (269,967) | (280,766) | |
| Gross profit | 720,000 | 823,680 | 940,265 | 1,071,291 | 1,218,475 | |
| Less depreciation | (200,000) | (200,000) | (200,000) | (200,000) | (200,000) | |
| Pre-tax profit | 520,000 | 623,680 | 740,265 | 871,291 | 1,018,475 | |
| Less 40% Argentine taxes | 40% | (208,000) | (249,472) | (296,106) | (348,517) | (407,390) |
| Net income | 312,000 | 374,208 | 444,159 | 522,775 | 611,085 | |
| Add back depreciation | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | |
| Annual project cash flow | 512,000 | 574,208 | 644,159 | 722,775 | 811,085 | |
| Sales value in year 5 (multiple of earnings) | 3,666,509 | |||||
| Initial investment, total | (2,000,000) | |||||
| Free cash flow for discounting | $ (2,000,000) | $ 512,000 | $ 574,208 | $ 644,159 | $ 722,775 | $ 4,477,594 |
| Internal rate of return (IRR) | 38.2% | |||||
| Net present value (NPV) | $ 1,942,351 | |||||
| The Parent Viewpoint needs to consider all incremental cash flow impacts, including loss on export sales to Argentina (current practice). | ||||||
| Cash Flows to Hermosa in US: Parent Viewpoint | ||||||
| Sales revenue on exports to Argentina | $ 240,000 | $ 249,600 | $ 259,584 | $ 269,967 | $ 280,766 | |
| Less direct and indirect costs on exported sets | (120,000) | (124,800) | (129,792) | (134,984) | (140,383) | |
| Profit on Hermosa's component sales | $ 120,000 | $ 124,800 | $ 129,792 | $ 134,984 | $ 140,383 | |
| Less US taxes on component profits @ 40% | 40% | (48,000) | (49,920) | (51,917) | (53,993) | (56,153) |
| a) Net profit on component sales after-tax | $ 72,000 | $ 74,880 | $ 77,875 | $ 80,990 | $ 84,230 | |
| b) Cash flow from Argentina to Hermosa (US) | $ 512,000 | $ 574,208 | $ 644,159 | $ 722,775 | $ 811,085 | |
| Cash flow loss on Hermosa's loss of exports | (480,000) | (499,200) | (519,168) | (539,935) | (561,532) | |
| Less US taxes on export losses | 40% | 192,000 | 199,680 | 207,667 | 215,974 | 224,613 |
| c) Net cash flow reduction after-tax | $ (288,000) | $ (299,520) | $ (311,501) | $ (323,961) | $ (336,919) | |
| d) Cash flow from sale of Argentine subsidiary (not taxed) | $ 3,666,509 | |||||
| Total parent cash flow, after-tax (a+b+c+d) | 296,000 | 349,568 | 410,533 | 479,804 | 4,224,904 | |
| Initial investment | (2,000,000) | |||||
| Free cash flow to parent for discounting | $ (2,000,000) | $ 296,000 | $ 349,568 | $ 410,533 | $ 479,804 | $ 4,224,904 |
| Internal rate of return (IRR) | 28.8% | |||||
| Net present value (NPV) | $ 1,166,501 | |||||
| The project is acceptable on both levels. The higher sale value results in a significant increase in the project net cash flows to the US parent. | ||||||
Pbm18.10
| Problem 18.10 Hermosa Components: Revenue Growth, Sales Price, and Currency Risk Scenario | ||||||
| Melinda Deane, a new analyst at Hermosa and a recent MBA graduate, believes that it is a fundamental error to evaluate the Argentine project’s prospective earnings and cash flows in dollars, rather than first estimating their Argentine peso (Ps) value, and then converting cash flow returns to the U.S. in dollars. She believes the correct method is to use the end-of-year spot rate in 2012 of Ps3.50/$ and assume it will change in relation to purchasing power. (She is assuming U.S. inflation to be 1% per annum, Argentine inflation to be 5% per annum). She also believes that Hermosa should use a risk-adjusted discount rate in Argentina that reflects Argentine capital costs (20% is her estimate), and a risk-adjusted discount rate for the parent viewpoint capital budget (18%), on the assumption that international projects in a risky currency environment should require a higher expected return than other lower risk projects. How do these assumptions and changes alter Hermosa’s perspective on the proposed investment? | ||||||
| Assumptions | Value | Growth | Assumptions | Value | ||
| Light bulb export volume to Argentina, per year | 24,000 | 4.00% | Sales multiple in year 5 | 6.00 | ||
| Sales price per set in Argentina | $ 60.00 | 7.00% | Spot rate, 2003 (Pesos/US$) | 3.50 | ||
| Material costs per set in Argentina | $ 20.00 | 6.00% | US inflation rate, per annum | 1.00% | ||
| Material and shipping costs of imports per set | $ 10.00 | 0.00% | Argentine inflation rate, per annum | 5.00% | ||
| Direct & indirect cost per set | $ 5.00 | 0.00% | Discount rate in United States | 18.00% | ||
| Depreciable investment (buildings & equipment) | $ 1,000,000 | |||||
| Initial investment in net working capital | $ 1,000,000 | |||||
| Discount rate in Argentina | 20.00% | |||||
| Project Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Year | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
| PPP Expected Exchange Rate (Pesos/US$) | 3.50 | 3.64 | 3.78 | 3.93 | 4.09 | 4.25 |
| Project Cash Flows in Argentina: Project Viewpoint (Argentine pesos) | ||||||
| Annual units sold (sets) | 24,000 | 24,960 | 25,958 | 26,997 | 28,077 | |
| Sales price in Argentina per set (in US$) | $ 60.00 | $ 64.20 | $ 68.69 | $ 73.50 | $ 78.65 | |
| Sales price in Argentina per set (in pesos) | 218.32 | 242.85 | 270.14 | 300.50 | 334.27 | |
| Sales revenue (Argentine pesos) | 5,239,604 | 6,061,547 | 7,012,430 | 8,112,479 | 9,385,094 | |
| Less direct manufacturing and shipping costs | (1,746,535) | (2,001,632) | (2,293,990) | (2,629,048) | (3,013,046) | |
| Less cost of US components @ $10/set | (873,267) | (944,166) | (1,020,821) | (1,103,700) | (1,193,307) | |
| Gross profit | 2,619,802 | 3,115,749 | 3,697,619 | 4,379,731 | 5,178,741 | |
| Less depreciation | (700,000) | (700,000) | (700,000) | (700,000) | (700,000) | |
| Pre-tax profit | 1,919,802 | 2,415,749 | 2,997,619 | 3,679,731 | 4,478,741 | |
| Less 40% Argentine taxes | 40% | (767,921) | (966,299) | (1,199,048) | (1,471,892) | (1,791,496) |
| Net income | 1,151,881 | 1,449,449 | 1,798,571 | 2,207,838 | 2,687,245 | |
| Add back depreciation | 700,000 | 700,000 | 700,000 | 700,000 | 700,000 | |
| Annual project cash flow | 1,851,881 | 2,149,449 | 2,498,571 | 2,907,838 | 3,387,245 | |
| Sales value in year 5 (multiple of earnings) | 16,123,468 | |||||
| Initial investment, total | (7,000,000) | |||||
| Free cash flow for discounting (pesos) | (7,000,000) | 1,851,881 | 2,149,449 | 2,498,571 | 2,907,838 | 19,510,713 |
| Internal rate of return (IRR) | 43.9% | |||||
| Net present value (NPV) | 6,725,072 | |||||
| The Parent Viewpoint needs to consider all incremental cash flow impacts, including loss on export sales to Argentina (current practice). | ||||||
| Cash Flows to Hermosa in US: Parent Viewpoint | ||||||
| Sales revenue on exports to Argentina | $ 240,000 | $ 249,600 | $ 259,584 | $ 269,967 | $ 280,766 | |
| Less direct and indirect costs on exported sets | (120,000) | (124,800) | (129,792) | (134,984) | (140,383) | |
| Profit on Hermosa's component sales | $ 120,000 | $ 124,800 | $ 129,792 | $ 134,984 | $ 140,383 | |
| Less US taxes on component profits @ 40% | 40% | (48,000) | (49,920) | (51,917) | (53,993) | (56,153) |
| a) Net profit on component sales after-tax | $ 72,000 | $ 74,880 | $ 77,875 | $ 80,990 | $ 84,230 | |
| b) Cash flow from Argentina to Hermosa (US) | $ 508,952 | $ 568,229 | $ 635,360 | $ 711,263 | $ 796,964 | |
| Cash flow loss on Hermosa's loss of exports | (480,000) | (499,200) | (519,168) | (539,935) | (561,532) | |
| Less US taxes on export losses | 40% | 192,000 | 199,680 | 207,667 | 215,974 | 224,613 |
| c) Net cash flow reduction after-tax | $ (288,000) | $ (299,520) | $ (311,501) | $ (323,961) | $ (336,919) | |
| d) Cash flow from sale of Argentine subsidiary (not taxed) | $ 3,793,593 | |||||
| Total parent cash flow, after-tax (a+b+c+d) | 292,952 | 343,589 | 401,735 | 468,293 | 4,337,868 | |
| Initial investment | (2,000,000) | |||||
| Free cash flow to parent for discounting | $ (2,000,000) | $ 292,952 | $ 343,589 | $ 401,735 | $ 468,293 | $ 4,337,868 |
| Internal rate of return (IRR) | 29.1% | |||||
| Net present value (NPV) | 684,343 | |||||
| The project is acceptable on both levels, despite the deteriorating peso scenario and the higher discount rates. | ||||||
| Note: One way of checking the accuracy of your spreadsheet solution is to assume that the initial spot rate is Ps1.00/$, and the inflation rates | ||||||
| in both countries are zero. The results should be identical to those in the previous problem. | ||||||
