Question Details

Compare the present value of the expected cash flows 



Capital Budgeting Analysis. 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.
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1) × (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
4. Variable cost per unit NZ$30 NZ$35 NZ$40
5. Total variable cost = (1) × (4) NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
6. Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
7. Interest expense of New
Zealand loan NZ$2,800,000 NZ$2,800,000 NZ$2,800,000
8. Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
9. Total expenses
= (5) + (6) + (7) + (8) NZ$15,000,000 NZ$15,550,000 NZ$16,200,000
10. Before-tax earnings of subsidiary
= (3) - (9) NZ$5,000,000 NZ$10,000,000 NZ$15,600,000
11. Host government tax (30%) NZ$1,500,000 NZ$3,000,000 NZ$4,680,000
12. After-tax earnings of subsidiary NZ$3,500,000 NZ$7,000,000 NZ$10,920,000
13. Net cash flow to subsidiary
= (12) + (8) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
14. NZ$ remitted by sub.
(100% of CF) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
15. Withholding tax imposed on
remitted funds (10%) NZ$850,000 NZ$1,200,000 NZ$1,592,000
16. NZ$ remitted after withholding
taxes NZ$7,650,000 NZ$10,800,000 NZ$14,328,000
17. Salvage value NZ$52,000,000
18. Exchange rate of NZ$ $.52 $.54 $.56
19. Cash flows to parent $3,978,000 $5,832,000 $37,143,680
20. PV of parent cash flows
(20% of discount rate) $3,315,000 $4,050,000 $21,495,185
21. Initial investment by parent -$25,000,000
22. Cumulative NPV of cash flows -$21,685,000 -$17,635,000 $3,860,185
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 parent- 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 project- 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 Wolverine- 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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