Question

Downtown Street, a British Company, is considering establishing an operation in the United States to assemble and distributes top hats. The initial investment is estimated to be £20,000,000 (British pounds - GBP) which is equivalent to US$23,000,000 at the current exchange rate. Given the current corporate income tax rate in the United States, Downtown Street estimates that total after-tax annual cash flow in each of the three years of the investments life would be US$10,000,000, US$12,000,000, and US$15,000,000, respectively. However, the U.S. national legislature is considering a reduction in the corporate income tax rate that would go into effect in the second year of the investment’s life, and would result in the following total annual cash flows: US$10,000,000 in year 1, US$14,000,000 in year two, and US$18,000,000 in year three. Downtown Street estimates the probability of the tax rate reduction occurring at 50%. Downtown Street uses a discount rate of 12% evaluating potential capital investments. Present value factors are as follows:

Period PV Factor

1 0.893

2 0.797

3 0.712

The U.S. operation will distribute 100% of its after-tax annual cash flow to Downtown Street as a dividend at the end of each year. The terminal value of the investment at the end of three years is estimated to be US$25,000,000. Neither the dividends nor the terminal value received from the U.S. investment will be subject to a British income tax.

Exchange rate between GBP and USD are forecasted as follows:

Year 1 GBP 0.74 = USD 1.00

Year 2 GBP 0.70 = USD 1.00

Year 3 GBP 0.60 = USD 1.00

Determine the expected net present value of the potential US investment from a parent company perspective.

Answer 1

Calculation of Present Value of future cash inflow

Cash flow considering current corporate income tax rate

Year	Cash Flow (in USD) (A)	Ex. Rate GBP/ USD (B)	Cash Flow (in GBP) (C = A x B)	PV Factor (D)	PV of Cash Flow (in GBP) (E = C x D)
1	10,000,000	0.74	7,400,000	0.893	6,608,200
2	12,000,000	0.70	8,400,000	0.797	6,694,800
3	15,000,000	0.60	9,000,000	0.712	6,408,000
Total					19,711,000

Cash flow considering reduction in corporate income tax rate

Year	Cash Flow (in USD) (A)	Ex. Rate GBP/ USD (B)	Cash Flow (in GBP) (C = A x B)	PV Factor (D)	PV of Cash Flow (in GBP) (E = C x D)
1	10,000,000	0.74	7,400,000	0.893	6,608,200
2	14,000,000	0.70	9,800,000	0.797	7,810,600
3	18,000,000	0.60	10,800,000	0.712	7,689,600
Total					22,108,400

Given that, probability of corporate tax reduction is 50%.

Expected PV of Cash Inflow = Cash inflow in current tax regime x 0.50 + Cash inflow in revised tax regime x 0.50

= 19,711,000 x 0.50 + 22,108,400 x 0.50

= 20,909,700

Expected NPV = Expected PV of Cash Inflow - PV of Cash Outflow

= 20,909,700 - 20,000,000

= GBP 909,700