Question

HepTones, Inc., is a U.S. based firm that designs and manufactures high-end stereo speakers. They have been successfully manufacturing and selling their speakers in the U.S. for the last five years. Although they are still somewhat small, their U.S. sales have been growing at a rate of 20% annually and HepTones has achieved an excellent reputation for providing high-quality products at reasonable prices. Based on their success in the U.S., HepTones would like to expand their production and sales to Asia. Since their speakers are heavy, bulky, and somewhat delicate, exporting U.S.-made speakers to Europe appears to be too expensive and risky.

HepTones’ Chief Financial Officer, Brenda Mendez, and her staff have been evaluating several potential production locations in Asia. Based on Ms. Mendez’ staff’s initial assessments, Ms. Mendez has narrowed the decision to one potential location—Delhi, India. Her decision was based on several criteria. First, average income in India has been growing rapidly in recent decades, and a viable market for HepTones’ products is emerging. Second, although there have been ups and downs, India has progressively implemented western-style economic, political, and business principles. Third, India’s labor force is well-educated and still relatively inexpensive compared to other Asian countries. Finally, transportation links between India and other Asian countries are also expanding rapidly, which bodes well for future exports to other Asian countries. Ms. Mendez has tasked you, as a financial analyst for HepTones, with preparing a more-extensive capital budgeting forecast for establishing a subsidiary in the Delhi location. She would like your recommendation as to whether the location is financially feasible and whether the locational decision is sensitive to any particular factors. She has asked you to use a 10-year forecasting horizon. Several departments at HepTones have provided you with the following information for your analysis:

• The building and equipment needed for production in Delhi can be acquired at a a cost of 600 million rupee. The equipment is valued at 300 million rupee and will be depreciated using straight-line depreciation, which implies 30 million of depreciation per year for 10 years.
• Estimated sales in the first year are 30,000 pairs of speakers at a per-unit price of 45,000 rupee. Unit sales are projected to increase at 20 percent per year in following years.
• The variable costs needed manufacture the speakers are estimated to be 40,000 per pair in the first year of production.
• Fixed operating expenses, such as administrative salaries will be 25 million rupee in the first year of operations.
• The Indian government will impose a 25 percent tax on income, and a 10 percent withholding tax on any funds remitted to the U.S. Any earnings remitted to the U.S. will not be taxed further.
• The Indian government has agreed to buy HepTones’ Indian subsidiary after 10 years for about 700 million rupee, after considering any capital gains.
• The current exchange rate for the Indian rupee is $0.015. The rupee is expected to depreciate by an average of 2 percent per year for the next 10 years.
• Average annual inflation in India is expected to be 10 percent. Revenues, variable costs, and fixed costs are expected to change by the same rate as annual inflation.

HepTones’ currently uses a 20 percent rate of return to evaluate potential investment projects in the U.S. It has decided to use a 25 percent rate of return to evaluate the Indian project. All excess funds generated by the Indian subsidiary will be remitted back to the U.S. Do your analysis in the tab called Baseline Scenario. After you have completed your analysis answer to the following question: Based on the information provided in the case, should HepTones proceed with the project? Why or why not? Please record your answer in the appropriate box in the tab called Questions. Ms. Mendez is somewhat concerned about the project made by the marketing department that unit sales will increase at a 20 percent annual rate. She is interested in knowing what annual rate of increase in sales would make the net present value (NPV) equal to zero. Anything less than this “break-even” rate of increase would mean the project is not financially feasible.To answer her question, make a copy of the Baseline Scenario worksheet. Rename it Sensitivity Analysis. Vary the sales rate increase until the NPV is approximately zero, and then answer this question: What annual rate of increase in sales will yield an NPV of zero? Please record your answer in the appropriate box in the tab called Questions.

Answer 1

		Present value of Cash flow=(Cash flow)/((1+i)^N)
		i=discount rate=25%=0.25
		N=year of Cash Flow
		BASELINE CASH FLOWv ANALYSIS				Current	Year 1
		Initial Cash Flow:				Exchange Rate	Exchange rate
		Building ($million)	$4.500	(300*0.015)	million	0.015/Rupee	0.0147	0.015*(1-0.02)
		Equipment($ million)	$4.500	(300*0.015)	million
		Total Initial outlay($ million)	$9.000	(600*0.015)	million
		Annual Depreciation in Rupees=300/10=	30.00	million
		After tax Salvage Value(Rupees million)	525	700*(1-0.25)	million
		Unit sales in year 1	30,000
		Unit sales in year 2	36,000	(30000*1.2)
		Unit Sales in Year (N+1)=1.2*(Unit Salesin year (N)
		Annual Cash Flow(RUPEES)
	N	Year	1	2	3	4	5	6	7	8	9	10
	a	Sales in Units	30,000	36,000	43,200	51,840	62,208	74,650.0	89,580	107,496	128,995	154,794
	b	Sales price per unit (Rupees)(increasing annually at 10%)	45,000	49,500	54,450	59,895	65,885	72,473	79,720	87,692	96,461	106,108
	c=a*b	Sales Revenue(Rupeesmillion)	1,350	1,782	2,352	3,105	4,099	5,410	7,141	9,427	12,443	16,425
	d	Unit Variable Cost(Rupees)(Increasing annually at 10%)	40,000	44,000	48,400	53,240	58,564	64,420	70,862	77,949	85,744	94,318
	e=a*d	Total Variable Costs (Rupees million)	1,200	1,584	2,091	2,760	3,643	4,809	6,348	8,379	11,060	14,600
	f	Fixed Operating Cost (Rupees million)(increaseing at 10%)	25	27.50	30.25	33.28	36.60	40.26	44.29	48.72	53.59	58.95
	g	Depreciation expenses(millionRupees)	30.00	30.00	30.00	30.00	30.00	30.00	30.00	30.00	30.00	30.00
	h=c-e-f-g	Profit before tax(Rupees million)	95.00	140.50	201.11	281.72	388.79	530.86	719.19	968.68	1,298.97	1,736.03