Question

Ace, Inc., a US company, has been approached by Lakson Group, a company from Pakistan, to explore the possibility of a joint venture in Pakistan to produce widgets. Ace is currently exporting 100,000 widgets a year to Pakistan? importer SS Import-Export Co. at 5,000 Pakistan rupees (PKR) each. The spot exchange rate is 100 PKR per $1. Currently, each widget costs Ace $30 to produce and ship to Pakistan. However, the current import agreement Ace has obtained from the Pakistani government is scheduled to expire. Ace estimates that joint venture sales in Pakistan will be 105,000 widgets the first year of operations, increasing 5% annually thereafter. Production of widgets in Pakistan requires the construction of a plant which, at the prevailing spot exchange rate, has an immediate cost of $6,000,000 to be equally shared by the two firms. The plant could be depreciated on a straight-line basis over 8 years. In addition, it is estimated that at the prevailing spot exchange rate each partner must contribute $500,000 of net working capital right away to launch the joint venture. The total cost of production in Pakistan is currently estimated to be 2300 PKR per widget and is expected to remain unchanged over the following five years. Part of this cost is for components produced by Ace in the US, at a cost of $5, and then supplied to the joint venture plant in Pakistan at $7 per widget. SS Import-Export has agreed to buy the widgets produced in Pakistan over the next five years at the same price it currently pays to import them from the US. The applicable tax rate in Pakistan, and in the US, is 35%. After five years of operations, Ace will pull out of the joint venture and in return it will recover in full its investment in net working capital and it will also sell its share of the plant to Lakson for an amount equal to 110% of its share of the plant’s book value at that time. To promote investment by US firms in Pakistan, the US government has agreed that the sale of Ace’s share of the plant to Lakson five years from now has no tax implications. In addition, the Pakistani government has agreed that at the end of each of the five years of operations, Ace may remit its share of the joint venture’s net cash flows to the US at the prevailing exchange rate. You are in charge of evaluating the joint venture for Ace. You believe that projects similar to that in the joint venture would require a 12% rate of return if undertaken in the US. Further, your assistant has provided the following input about the projected inflation rates over the next five years:

Year 1 2 3 4 5

US 1% 1% 2% 2% 2%

Pakistan 3% 4% 6% 6% 6%

1. What would be your recommendation to Ace? Make sure you provide calculations using the “foreign country approach” and the “home country approach” and explain to the management of the two partner firms what the dollar denominated NPV of the joint venture to Ace is under each of these two approaches. (Note: To enable comparisons across students, please explain in detail your calculations for t = 2, as well as for any special, one time, items you encounter at t = 0 and t = 5 in your analysis.)

2. Assume that Ace decides to enter in the joint venture. However, Ace has only $1,500,000 in cash available for investment in the project. Hence, Ace wants to get a two year dollardenominated loan now from its US bank at 10% annual interest rate against its share of the joint venture’s first and second year net cash flows. How much would Ace be able to borrow if it enters in to a forward contract at 102.5 PKR per $1? Would the total of the loan and the cash currently available enable Ace to proceed with the project?

3. Assume Ace enters in the joint venture and Bank of Khyber, a Pakistani bank, offers to remit all future net cash flows to Ace at the fixed exchange rate of 110 PKR per $1 for a $20,000 fee payable immediately. Would you recommend that Ace accepts this offer or not?

4. What are the additional risks Ace faces by stepping into an international joint venture with Lakson Group as opposed to having a similar domestic joint venture with a US firm? Have you accounted for any of these risks in your evaluation of the joint venture of Ace with Lakson Group? If yes, how?

Answer 1

Cost of the plant =		$6,000,000
Depreciation on straight line basis =				$750,000
Initial contribution to working capital =				$500,000
Cost of production per widget =			2300	PKR
This year:
Units sold this year =		100,000
Sale price per unit =		5000	PKR
Cost per unit of widget =			$30
Increase in sales per year =			5%
Tax Rate =	35%
Exchange rate =	100	PKR per USD
(in PKR)
Year	0	1	2	3	4	5
Initial Investment	$6,000,000
Contribution to working capital	$500,000
Revenues		500000000	525000000	551250000	578812500	607753125
Costs		230000000	230000000	230000000	230000000	230000000
Depretiation		75000000	75000000	75000000	75000000	75000000
Operating profit		195000000	220000000	246250000	273812500	302753125
Tax (35%)		68250000	77000000	86187500	95834375	105963594
Earning after tax		126750000	143000000	160062500	177978125	196789531
Cash flow		201750000	218000000	235062500	252978125	271789531
Total cash flows	-650000000	201750000	218000000	235062500	252978125	271789531
Discount rate =	12%
Therefore,
NPV of the Joint Venture =		186227889.4	PKR	or	$ 1,862,278.89
For the calculation of the NPV before the Joint Venture:
Year	0	1	2	3	4	5
Revenues		500000000	500000000	525000000	551250000	578812500
Cost		300000000	300000000	300000000	300000000	300000000
Operating Profit		200000000	200000000	225000000	251250000	278812500
Tax (35%)		70000000	70000000	78750000	87937500	97584375
Cash Flows		130000000	130000000	146250000	163312500	181228125
Doiscount rate =	12%
Therefore,
NPV of the pre joint venture deal =			$5,304,262.45
Which is much higher than The Joint venture valuation.