Funds to cover the working capital


Problem:

After conducting a comprehensive country risk analysis of New Zealand, the Wolverine Corporation, a U.S.-based MNC, has decided to establish a subsidiary in that country as its mode of market entry. The following information has been gathered to assess the feasibility of this project:

The initial investment required is $50 million in New Zealand dollars (NZ$). Given the existing spot rate of $.50 per NZ 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%. 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% on income. In addition, it will impose a withholding tax of 10% 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 generated 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 3 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 liquated, 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 this amount is not subject to a withholding tax.

Wolverine requires a 20% rate of return on this project, translated to mean its hurdle rate or weighted average cost of capital.

Based on this information, answer the following questions:

Question 1. Determine the Net Present Value (NPV) of the Wolverine Corporation multinational expansion project and recommend whether Wolverine should accept or reject it. Discuss your recommendation. NPV = $2,229,867 because it is positive it should be accepted.

Question 2. Assume that Wolverine is 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 taking the New Zealand bank 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. Use NPV analysis to determine the impact of this alternative financing arrangement on the firm's decision to accept or reject the New Zealand project.

Question 3. From the parent's perspective, would the NPV of this project be more sensitive to exchange fluctuations 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.

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Finance Basics: Funds to cover the working capital
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