Question

(1) The foreign project has a life of three years. The initial investment on long-term capital is $60m.

(2) Annual revenue in each of the three years will be ¥ 6000m. Annual costs of goods sold will be ¥ 3000m.

(3) Japan: beta =1.2, Rf = 4%, Rm = 6%, Rd= 7%, 30% debt and 70% equity;

        US: beta =2, Rf = 3%, Rm = 7%, Rd= 4%, 30% debt and 70% equity.

(4) Current spot rate: ¥100/$; Annual inflation rate in Japan is 3%; Annual inflation rate in the US is 2%.

(5) Corporate tax rate is 30%; straight-line depreciation method; investment in long-term capital fully depreciated over three years.

What is the after-tax cost of debt in Japan?

What is the cost of equity in the US?

What is the cost of capital in the US?

What is the exchange rate at the end of the third year in the life of the project?

What is the dollar cash flow occurring in the second year?

What is the NPV of the project from the parent’s viewpoint?

The parent (i.e., U.S.) firm should conclude that the project is good?

Answer 1

(1) after-tax cost of debt in Japan

= rate of debt (1- tax rate)

= 7% (1-0.30)

= 4.9%

(2) cost of equity in US

= Rf + Beta( Rf -Rm)

= 3 % + 2 ( 7% - 3% )

= 11%

(3) cost of capital in US

= cost of equity * wieght of equity + cost of debt (1-tax rate) * wieght of debt

= 11% * 0.70 + 4%(1-0.30) * 0.30

= 8.54 %

(4) exchange rate at the end of third year as per purchasing power parity ( using inflation rate)

= spot rate *(1+0.03 / 1+0.02)3

= ¥100*1.0297

US dollor = ¥102.97

(5) cash flow in us dollar in second year

exchange rate in second year =spot rate *(1+0.03 / 1+0.02)2

  =¥100 *1.0197

= ¥101.97

Dep = (60m * ¥100 ) / 3 year = ¥2000

cash flow in dollar in second year = {(Revenue- COGS -Dep) - tax } / exchange rate second year end

(¥ 6000 m- ¥3000 m-2000 m- 300 m) /¥101.97 = 6.685 million

(6) NPV of the project

profit after tax in each year = ¥700

NPV = initial investment + PVAF (8.64 % , 3 year) * profit after tax per year

= - ¥ 6000 m + 2.5476 * ¥ 700

= - ¥ 4216.66 m

in US dollar = ¥4216.66 / 102.97 = - $ 40.95 million

*** NPV may calculate alternatively by converting each year net cash inflow to us dollar by using exchange rate ( may calculate by using inflation rate)

conclusion - it is conclude that not to continue with this