Question

Steele Corp., a U.S. company, plans to establish a subsidiary in Australia. An initial investment of A$53 million is required for the Australian subsidiary. The Australian government will impose a withholding tax of 12 percent on earnings remitted by the Australian subsidiary. Steele is subject to 35 percent corporate tax in the U. S. As for Steele’s subsidiary in Australia, it is subject to 30 percent corporate tax rate. The U.S. government will not impose any taxes on the A$ income. At the end of year 3, the Australian subsidiary expects to receive a salvage value of A$45 million after subtracting capital gains taxes. This amount is not subject to a withholding tax by the Australian government.

For the Australian subsidiary, Steele uses its cost of capital as the project’s discount rate. Steele’s capital structure is 40 percent debt and 60 percent equity. The after-tax cost of debt and equity for Steele are 10 percent and 25 percent, respectively. The table below provides the relevant information for Steele Corp. at the end of each corresponding year:

	Now	Year 1	Year2	Year 3
Initial outlay (A$)	53,000,000
Cash remitted back (A$)		8,500,000	12,000,000	15,920,000
Salvage value (A$)				45,000,000
Exchange rate estimates ($/A$)	0.50	0.52	0.54	0.56
Forward rate		0.50	0.545	0.55

Required:

1. Calculate the US$ amount that Steele Corp would receive at the end of year 1, 2, and 3 assuming that Steele converts the A$ using the exchange rate estimates.

2. Calculate the relevant discount rate for the Australian project and using the cash flows calculated in part (a), determine the net present value (NPV) of this project. Should Steele Corp invest in this project? Why?

3. Suppose, Steele wants to hedge the foreign exchange risk by engaging in the forward contracts. Calculate the NPV the hedged position. Should the company hedge? Why?

Answer 1

Information given in question		Amounts in Aust. A$
Initial Outlay for Autralian Sbusidiary		5,30,00,000
Withholding Tax in Australia			12%
Corporate tax in US				35%
Corporate tax in Aust.			30%
Salvage value at the end of year 3		4,50,00,000
Capital Structure	Debt	40%
		Equity	60%
After tax Cost of:	Debt	10%
		Equity	25%

Working Notes
Calculation of WACC
Capital Struture (a)	Cost of capital (b)	(a)x(b)
Debt	40%	10%		4.00%
Equity	60%	25%		15.00%
WACC	19.00%
Calculation of Depreciation
Depreciation = Project cost-Salvage Value/Number of years
Project Cost	5,30,00,000
Salvage Value	4,50,00,000
		80,00,000
No. of Years	3
Depreciation/Year	26,66,667
Calculation of Interest
40% of the project is Debt financed
So 40% of 53000000 is	2,12,00,000
After tax Interest cost	10%
Tax rate (USA)		35%
Before Tax Interest Cost	15%	(Rounded Off)
Before tax Interest		31,80,000	(p.a)

	Solution
					Year 1	Year 2	Year3	year 3
1	Cash remmitence			85,00,000	1,20,00,000	1,59,20,000
2	Depreciation			26,66,667	26,66,667	26,66,667
3	Interest				31,80,000	31,80,000	31,80,000
4	EBT				26,53,333	61,53,333	1,00,73,333
5	Corporate tax @ 30%(4x5)		7,96,000	18,46,000	30,22,000
6	EAT(4-5)				18,57,333	43,07,333	70,51,333
7	Add back Depreciation(6+2)		26,66,667	26,66,667	26,66,667
8	Cash inflow(6+7)			45,24,000	69,74,000	97,18,000
9	Salvage Value						4,50,00,000
10	Discounting Factor @ 19% (WACC)	0.8403	0.7062	0.5934	0.5934
11	PV of Inflow (8x10)			38,01,680.67	49,24,793.45	57,66,814.88	2,67,03,711.64
12	Less: Withholding Tax @ 12%(11x12)	4,56,201.68	5,90,975.21	6,92,017.79	32,04,445.40
13	Available for Remmitence is A$(11-12)	33,45,478.99	43,33,818.23	50,74,797.10	2,34,99,266.24
14	Eaxchange rate $/A$		0.52	0.54	0.56	0.56
15	Value in $ Available for Remmitence	64,33,613.45	80,25,589.32	90,62,137.67	4,19,62,975.43

A)   

Year 1	Year 2	Year3
64,33,613.45	80,25,589.32	5,10,25,113.10

B (a)

Calculation of relevent Discount rate
Capital Struture (a)	Cost of capital (b)	(a)x(b)
Debt	40%	10%		4.00%
Equity	60%	25%		15.00%
WACC	19.00%

B (b) NPV in A$

NPV PV of Cash inflow - Pv of cash outflow
Cash inflow		4,11,97,000.64	(Total of A$ Inflow)
Cash Outflow		5,30,00,000	(Initial A$ Outflow)
NPV			-1,18,02,999.36

NPV in US$

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