Question

A US multinational corporation has operations in Bolivia through which it plans to sell a new product of 500,000 cans of beans per year for the next 3 years, at a price of BOB 4 per can after incurring a variable cost of BOB 2.50 per can. The company will also incur a fixed cost of BOB 120,000 per year. The company has invested BOB 900,000 today in manufacturing equipment for its Bolivian operations, which will be depreciated to $0 at the end of its 3-year life. The corporation’s required rate of return is 20% and has a tax rate of 25%. The spot rate was BOB 6.91/$ before it unexpectedly changed to BOB 7.25/$.

a.) What is the value of the Bolivian operations prior to the unexpected change in the spot rate assuming the operations have a 3-year life only? (round to the nearest dollar)

b.)What is the value of the Bolivian operations after the unexpected change in the spot rate assuming the operations have a 3-year life only? (round to the nearest dollar)

c.) What is the foreign exchange operating gain/loss resulting from the unexpected change in the spot rate? (round to the nearest dollar)

d.)What is the impact on the value of the Bolivian operations if the US multinational decided to increase the domestic price to BOB 4.90, which will likely cause a decline in the number of units sold by 75,000?

e.) What is the impact on the value of the Bolivian operations if the US multinational decided to increase the number of units sold by 75,000, which will likely cause an increase in the direct cost per until to BOB 2.55? (round to the nearest dollar)

f.) What percent increase in Bolivian Bolivianao (BOB) (selling) price would be necessary to minimize the effect of the unexpected change in spot on the value of the Bolivian operation, assuming all else remains unchanged? (round your answer)

Answer 1

(a) Value of Bolivian operations prior to unexpected spot rate:

Given, No.of units sold = 5,00,000 cans

Selling price = BOB 4, Variable cost = BOB 2.50

Initial investment = BOB 9,00,000

Life = 3 Years

Spot rate (BOB/$) = 6.91

Value of operations:

Particulars	Years 1 to 3
Sales(5,00,000×4)	20,00,000
Less: Variable [email protected] per unit	(12,50,000)
Contribution	7,50,000
Less: Fixed cost	(1,20,000)
Less: Depreciation (9,00,000÷3)	(3,00,000)
EBT	3,30,000
Less: Tax@25%	(82,500)
EAT	2,47,500
Add: Depreciation	3,00,000
CFAT	5,47,500
PVAF(20%,3) = [1-1÷(1+0.20)^3]÷0.20	2.1065
Present value(5,47,500×2.1065)	11,53,309
Equivalent value in $(11,53,309÷6.91)	$1,66,904

Therefore value of Bolivian of = $1,66,904

(b) Value of Bolivian operations after unexpected change in spot rate:

Spot rate after change (BOB/$) = 7.25

Value of operations = 11,53,309÷7.25 = $1,59,077

(c) What is foreign exchange operating gain or loss due to unexpected change in spot rate:

As there is Receivable in BOB, if BOB Currency decreases, it results in loss of value

As there is decline in exchange rate from 6.91 to 7.25, BOB depreciated

Hence loss = 1,66,904 - 1,59,077= $7,827

(d) Impact on value of operations if US multinational decides to increase the domestic price to BOB 4.90 and there is likely decrease in no. of units sold by 75,000:

On decrease in no. of units sold by 75,000

Total no. of units to be sold = 5,00,000 - 75,000

= 4,25,000 units

Value of operations:

Particulars	Years 1 to 3
Sales@4,25,000×4.90	20,82,500
Less: Variable cost @2.5 per unit	(10,62,500)
Contribution	10,20,000
Less: Fixed cost	(1,20,000)
Less: Depreciation	(3,00,000)
EBT	6,00,000
Less: Tax@25%	(1,50,000)
EAT	4,50,000
Add: Depreciation	3,00,000
CFAT	7,50,000
PVAF(20%,3)	2.1065
Present value (7,50,000×2.1065)	15,79,875
Equivalent value in [email protected]	2,17,914

After change in unexpected spot rate

Value before change in domestic price and no. of units = $1,59,077

Value after change in domestic price and no. of units = $2,17,914

Gain on increase in domestic price and decrease in no. of units by 75,000 = 2,17,914 - 1,59,077 = $58,837

(e) Impact on value of operations if US multinational decides to increase Direct cost per unit to BOB 2.55 and there is likely increase in no. of units sold by 75,000:

On Increase in no. of units sold by 75,000

Total no. of units to be sold = 5,00,000+75,000 = 5,75,000

Value of operations:

Particulars	Years 1 to 3
Sales@5,75,000×4	23,00,000
Less: Variable [email protected] per unit	(14,66,250)
Contribution	8,33,750
Less: Fixed cost	(1,20,000)
Less: Depreciation	(3,00,000)
EBT	4,13,750
Less: Tax@25%	(1,03,437.5)
EAT	3,10,312.5
Add: Depreciation	3,00,000
CFAT	6,10,312.5
PVAF(20%,3)	2.1065
Present value of CFAT (6,10,312.5×2.1065)	12,85,623.28
Equivalent value in $ @7.25	1,77,327.35

After change in unexpected spot rate,

Value before change in Direct cost and no. of units= $1,59,077

Value after change in Direct cost and no. of units = $1,77,327.35

Gain on increase in no. of units by 75,000 and increase in Direct cost = 1,77,327.35 - 1,59,077 = $18,250.35

(f) What percentage change in Bolivian selling price would be necessary to maximize the effect of unexpected change in spot on the value of Bolivian operations assuming all else remains unchanged?

To maximize the effect of unexpected change in spot rate, value of Bolivian operations shall be $1,66,904 × 7.25 = BOB 12,10,054

Let us reverse Calculate in order to arrive at the new selling price which is as follows:

Particulars	Years 1 to 3
Value of Bolivian operations in BOB	12,10,054
PVAF (20%,3)	2.1065
CFAT p.a. [12,10,054÷2.1065]	5,74,438.17
Less: Depreciation	(3,00,000)
EAT	2,74,438.17
Add: Tax@25% [2,74,438.17×25÷75]	91,479.39
EBT	3,65,917.56
Add: Depreciation	3,00,000
Add: Fixed cost	1,20,000
Contribution	7,85,917.55
Add: Variable cost [5,00,000×2.5]	12,50,000
Sales	20,35,917.55
Selling price [20,35,917.55÷5,00,000]	4.072

Therefore percentage increase in selling price to maximize the effect of unexpected spot rate is [(4.072 - 4)÷4]×100 = 1.8%