. 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:
■ 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 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 liquidated but will be used by the acquiring firm that buys 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?
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 not need 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’s 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’s 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 1 year, a New Zealand firm offers Wolverine a price of $27 million after taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not changed. Compare the present value of the expected cash flows if Wolverine keeps the subsidiary to the selling price. Should Wolverine divest the subsidiary? Explain.