Question

In: Finance

Steele Corp., a U.S. company, plans to establish a subsidiary in Australia. An initial investment of...

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.

  1. 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?

  1. 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?

Solutions

Expert Solution

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$

Cash inflow US$

Related Solutions

a) Scandina Corp., a Swedish furniture producer, plans to establish a subsidiary in Malaysia in order...
a) Scandina Corp., a Swedish furniture producer, plans to establish a subsidiary in Malaysia in order to penetrate the Asian market. The company’s managers believe that the value of Malaysian ringgit is relative weak now and will strengthen against the Swedish Krona over time. If their expectations about ringgit’s value are correct, how will this affect the costs and earnings of the project? Explain.    b) Scandina Corp. is also considering a joint venture with a Malaysian company IDEAL AS...
InventBear Inc. is planning to establish a subsidiary in Australia to produce and sell gaming products...
InventBear Inc. is planning to establish a subsidiary in Australia to produce and sell gaming products locally. The project will end in three years and the subsidiary will be sold to an Australian firm for A$5 million at the end of the project. The salvage value is net of tax and will not be subject to withholding tax. InventBear estimates that, after paying for the income tax, the Australian subsidiary can remit A$5,450,000 to the parent every year for the...
Elvis Inc. is planning to establish a subsidiary in Australia to produce canola oil. The manufacturing...
Elvis Inc. is planning to establish a subsidiary in Australia to produce canola oil. The manufacturing facility will cost the parent company an initial investment of 5 million U.S. dollars (US$) to set up. The project will end in 3 years. At the end of the project, Elvis will sell the Australian subsidiary for A$8 million to an Australian agriculture firm. This amount is net of capital gain tax and is not subject to the withholding tax. Elvis estimates the...
The Williams Company, a U.S.-based company, owns 100% of a European Subsidiary (ES). The investment in...
The Williams Company, a U.S.-based company, owns 100% of a European Subsidiary (ES). The investment in ES totals $10 million (euros 13.5 million) as of the end of Year 1. This represents an initial investment of $6 million and retained earnings of $4 million. The Currency Translation Adjustment (CTA) account included in Other Comprehensive Income (OCI) totals $1 million (loss) at the end of Year 1. During Year 2, Williams decided to sell 25% of ES to the Tremont Company,...
A pharmaceutical company developed four investment plans. The initial investment and the corresponding annual cash flows...
A pharmaceutical company developed four investment plans. The initial investment and the corresponding annual cash flows of the four investment plans for consecutive 5 years are shown in the following Table Q1. Project Name I II III IV Initial Investment (OMR) 58000 68000 97000 119000 Annual Cash inflow (OMR) 16000 23000 29000 35000 Identify the best project and decide the ranking based on the following profitability methods. a) Average rate of return. b) Payback period. c) Net Present value with...
Q1. A pharmaceutical company developed four investment plans. The initial investment and the corresponding annual cash...
Q1. A pharmaceutical company developed four investment plans. The initial investment and the corresponding annual cash flows of the four investment plans for consecutive J years are shown in the following Table Q1. Project Name I II III IV Initial Investment (OMR) A B C D Annual Cash inflow (OMR) E F G H Identify the best project and decide the ranking based on the following profitability methods. a) Average rate of return. b) Payback period. c) Net Present value...
April Date 1 Acquired $55000 to establish the company, $33,000 from an initial investment through the...
April Date 1 Acquired $55000 to establish the company, $33,000 from an initial investment through the issue of common stock to themselves and $22,000 from a bank loan by signing a note. The entire note is due in five years and has a 7 per cent annual interest rate. Interest is payable in cash on March 31 of each year. 1 Paid $42000 (represents 3 months) in advance rent for a one-year lease on kitchen space. 1 Paid $35000 to...
5. Drysdale Co., a U.S. firm, considers to establish a Chinese subsidiary that produces cell phones...
5. Drysdale Co., a U.S. firm, considers to establish a Chinese subsidiary that produces cell phones in China and sells them in Singapore. This subsidiary pays its wages and its rent in Chinese yuan. The cell phones sold to Singapore are denominated in Singapore dollar. Assume that Drysdale Co. expects that the Chinese yuan will continue to stay stable against the U.S. dollar. The subsidiary’s main goal is to generate profits for itself and it reinvests the profits. It does...
Month of April Date April-01 Acquired $55000 to establish the company, $33000 from an initial investment...
Month of April Date April-01 Acquired $55000 to establish the company, $33000 from an initial investment through the issue of common stock to themselves and $22000 from a bank loan by signing a note. The entire note is due in 5 years and has 7 per cent annual interest rate. Interest is payable in cash on March 31 of each year. April-01 Paid $4200 (represents 3 months) in advance rent for a one-year lease on kitchen space. April-01 Paid $35000...
Month of April Date April-01 Acquired $55000 to establish the company, $33000 from an initial investment...
Month of April Date April-01 Acquired $55000 to establish the company, $33000 from an initial investment through the issue of common stock to themselves and $22000 from a bank loan by signing a note. The entire note is due in 5 years and has 7 per cent annual interest rate. Interest is payable in cash on March 31 of each year. April-01 Paid $4200 (represents 3 months) in advance rent for a one-year lease on kitchen space. April-01 Paid $35000...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT