Question Details

Determine the probability distribution of Gandor- net present values 



Gandor Company is a U.S. firm that is considering a joint venture with a Chinese firm to produce and
sell videocassettes. Gandor will invest $12 million in this project, which will help to finance the
Chinese firm- production. For each of the first three years, 50 percent of the total profits will be
distributed to the Chinese firm, while the remaining 50 percent will be converted to dollars to be sent
to the U.S. The Chinese government intends to impose a 20 percent income tax on the profits
distributed to Gandor. The Chinese government has guaranteed that the after-tax profits (denominated
in yuan, the Chinese currency) can be converted to U.S. dollars at an exchange rate of CHY1 = $.20
per unit and sent to Gandor Company each year. At the present time, no withholding tax is imposed on
profits sent to the U.S. as a result of joint ventures in China. Assume that even after considering the
taxes paid in China, an additional 10 percent tax imposed by the U.S. government on profits received
by Gandor Company. After the first three years, all profits earned are allocated to the Chinese firm.
The expected total profits resulting from the joint venture per year are as follows:
Year
Total Profits from Joint
Venture (in yuan, CHY)
1 CHY60 million
2 CHY80 million
3 CHY100 million
Gandor- average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent.
Assume that the corporate income tax rate imposed on Gandor is normally 30 percent. Gandor uses a
capital structure composed of 60 percent debt and 40 percent equity. Gandor automatically adds 4
percentage points to its cost of capital when deriving its required rate of return on international joint
ventures. Though this project has particular forms of country risk that are unique, Gandor plans to
account for these forms of risk within its estimation of cash flows.
Gandor is concerned about two forms of country risk. First, there is the risk that the Chinese
government will increase the corporate income tax rate from 20 percent to 40 percent (20 percent
probability). If this occurs, additional tax credits will be allowed, resulting in no U.S. taxes on the
profits from this joint venture. Second, there is the risk that the Chinese government will impose a
withholding tax of 10 percent on the profits that are sent to the U.S. (20 percent probability). In this
case, additional tax credits will not be allowed, and Gandor will still be subject to a 10 percent U.S.
tax on profits received from China. Assume that the two types of country risk are mutually exclusive.
This is, the Chinese government will adjust only one of its taxes (the income tax or the withholding
tax), if any.
1. Determine Gandor- cost of capital. Also, determine Gandor- required rate of return for the joint
venture in China.
2. Determine the probability distribution of Gandor- net present values for the joint venture.
Capital budgeting analyses should be conducted for these scenarios:
• Scenario 1 Based on original assumptions.
• Scenario 2 Based on an increase in the corporate income tax by the Chinese government.
• Scenario 3 Based on the imposition of a withholding tax by the Chinese government.
3. Would you recommend that Gandor participate in the joint venture? Explain.
4. What do you think would be the key underlying factor that would have the most influence on the
profits earned in China as a result of the joint venture?
5. Is there any reason for Gandor to revise the composition of its capital (debt and equity) obtained
from the U.S. when financing joint ventures like this?
6. When Gandor was assessing this proposed joint venture, some of its managers of recommended
that Gandor borrow the Chinese currency rather than dollars to obtain some of the necessary
capital for its initial investment. They suggested that such a strategy could reduce Gandor-
exchange rate risk. Do you agree? Explain.




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