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 NZDs (NZD). Given the existing spot rate of USD .50 per NZD, the initial investment in USDs is USD 25 million. The project will be terminated in 3 years.
Wolverine plans to finance the new investment by borrowing NZD 2 million from the local market. The New Zealand subsidiary will pay 5% percent. The loan will be fully paid in 3 years. Assume that the NZ subsidiary do not need any additional working capital.
Assuming integrated capital market, the risk free rate in the US is 4%, the equity risk premium is 5% and beta of the project is 0.95. The equity financing is 60% and debt financing is 40% for the project.
The project will be terminated at the end of Year 3, when the subsidiary will be sold. Wolverine expects to receive NZD 52 million. Assume that this amount is not subject to a withholding tax.
The price, demand, and variable cost of the product in New Zealand are as follows:
Year Price Demand Variable Cost
1 NZD 500 40,000 units NZD 30
2 NZD 511 50,000 units NZD 35
3 NZD 530 60,000 units NZD 40
The fixed costs, such as overhead expenses, are estimated to be NZD 6 million per year.
The exchange rate of the NZD is expected to be USD .52 at the end of Year 1 USD .54 at the end of Year 2 and USD .56 at the end of Year 3.
The New Zealand government will impose an income tax of 20 % on income. The US corporate income tax is 35 %. Any cash flow sent by the subsidiary is subject to 5% withholding tax.
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 NZD 6,000,000 and depreciated over 3 years using the straight-line depreciation method.
a) Estimate WACC for the project.
b) Calculate the NPV & IRR from the perspective of the subsidiary.
c) Calculate the NPV & IRR from the perspective of the parent.
d) Should Wolverine Corp accept this project? If not explain what could the parent company do?