Question

TechMedia, Inc. is a U.S. firm that is planning to build a new production facility in either the USA or China. The initial cost to build the facility will be $8.2 million if built in the USA or ¥45 million if built in China. In either location, the project will require an initial investment of $225,000 in net working capital. Net working capital at the end of each of years 1 through 4 will be $65,000. Net working capital will be $0 at the end of the fifth (final) year of the project. The current exchange rate between the two currencies is 6.75 ¥/$. The risk-free rate in the U.S. is 0.8% and the risk-free rate in China is 6.1%. TechMedia, Inc. pays a 35% tax rate on its taxable income. The firm’s current and target debt-equity ratio is 0.6. Its cost of debt is 6.5% and its cost of equity is 11.5%. The facility will be fully depreciated over five years (straight line) with no salvage value. The facility is expected to impact the firm’s operating revenues and expenses as shown below. USA Location China Location Year Additional Revenue ($) Additional Expense ($) Additional Revenue (¥) Additional Expense (¥) 1 $4,000,000 $1,500,000 ¥20,000,000 ¥7,000,000 2 $4,000,000 $1,500,000 ¥25,000,000 ¥8,000,000 3 $5,000,000 $1,750,000 ¥30,000,000 ¥9,000,000 4 $6,500,000 $2,000,000 ¥35,000,000 ¥9,000,000 5 $6,500,000 $2,000,000 ¥40,000,000 ¥8,000,000 Which location, if either, should TechMedia, Inc. choose?

Answer 1

planning to build new production facility
Exchange rate	1$	=	6.75 Yen
option -A					option -B
		in USA			Chaina
Initial cost		$8.20	million		Yen 45	million
Net working capital(Y-0)		$225,000			$225,000
Net working capital(Y-1-4))		$65,000			$65,000
Risk free rate(Rf)		0.80%			6.10%
Tax@		35%			35%
Debt equity ratio		0.6			0.6
Cost of debt		6.50%			6.50%
Cost of equity		11.50%			11.50%
5years depreciation		$8200000/5			Yen45000000/5
		$1,640,000			9,000,000	Yen
		Year 1	Year 2	Year 3	Year 4	Year 5
Additional revenue		$4,000,000	$4,000,000	$5,000,000	$6,500,000	$6,500,000
Additional Expenses		($1,500,000)	($1,500,000)	($1,750,000)	($2,000,000)	($2,000,000)
Income		$2,500,000	$2,500,000	$3,250,000	$4,500,000	$4,500,000
Less - Depreciation		($1,640,000)	($1,640,000)	($1,640,000)	($1,640,000)	($1,640,000)
		$860,000	$860,000	$1,610,000	$2,860,000	$2,860,000
Less : Tax @35%		($301,000)	($301,000)	($563,500)	($1,001,000)	($1,001,000)
Net income after tax		$559,000	$559,000	$1,046,500	$1,859,000	$1,859,000
Working capital		($65,000)	($65,000)	($65,000)	($65,000)	($65,000)
cash inflow		$494,000	$494,000	$981,500	$1,794,000	$1,794,000
Discount at risk free rate @ 0.8%		$490,079	$486,190	$958,318	$1,737,722	$1,724,005		$5,396,315
initial working capital								$225,000
Net revenue from this project								$5,171,315
Additional revenue		20,000,000	25,000,000	30,000,000	35,000,000	40,000,000
Additional Expenses		-7,000,000	-8,000,000	-9,000,000	-9,000,000	-8,000,000
Net income		13,000,000	17,000,000	21,000,000	26,000,000	32,000,000
Depreciation		(9,000,000)	(9,000,000)	(9,000,000)	(9,000,000)	(9,000,000)
		4000000	8000000	12000000	17000000	23000000
		(1,400,000)	(2,800,000)	(4,200,000)	(5,950,000)	(8,050,000)
Net income in Yen		2,600,000	5,200,000	7,800,000	11,050,000	14,950,000
working capital		(438,750)	(438,750)	(438,750)	(438,750)	(438,750)
cash inflow		2,161,250	4,761,250	7,361,250	10,611,250	14,511,250
Discount at risk free rate @ 6.5%		0.606	0.367	0.223	0.135	0.082
(1/(1+6.5%))
present value of cash flow(2161250*0.606		1,309,848.48	1,748,852.16	1,638,701.06	1,431,629.93	1,186,547.43
Exchange in to $		1/6.75	1/6.75	1/6.75	1/6.75	1/6.75
Present value of cash flows in ($)		194,051.63	259,089.21	242,770.53	212,093.32	175,784.80		1,083,789.49
less :- Working capital								($225,000)
							$	858,789.49
Option A is better, since cash flows from that option is more.