Question

XYZ Corporation, an Australian based carmaker, is considering an expansion into Asia after its expansion into the US last summer was highly successful. Currently, XYZ does export cars to Asia, but the increased demand raises the question of an expansion in Asia. XYZ is trying to decide whether to establish a car manufacturing plant and office in Japan where cars would be built and then sold across Asia.

All relevant data is given in the tables below. The cost of the expansion is Yen 80,000,000, which must be immediately expended. Three-year EBITDA are 35,000,000 45,000,000 and 55,000,000 respectively. Moreover, XYZ would have to fund additional working capital of Yen 5,000,000 at the time of the expansion. Further investment in net working capital would be Yen 5,000,000, Yen 8,000,000, and Yen 10,000,000 in year 1, 2, and 3 respectively. If it builds the plant, XYZ will depreciate it at a rate of Yen 4,000,000 per year (starting in year 1) and will have to fund additional capital expenditures of Yen 8,000,000 per year to maintain and improve the plant. Although the project is assumed to have an infinite life, cash-flows are only projected up to three years and the terminal value of the project is computed based on the year 3 free cash-flow (FCF) assuming a growth rate that equals the Japanese long-run GDP growth rate.

All taxes are paid in Japan in the year the income is earned. Tax treaties are in effect so that XYZ will have no tax obligations to the Australian Tax Office (ATO). The following information applies to the valuation.

	Japan	Australia
Price Inflation	2.00%	3.00%
Annual return on government bonds	3.00%	4.00%
Corporate tax rate	40.00%	30.00%
Equity market risk premium AUD		6.00%
Spot rate-S(AUD/Yen)	0.01
Before tax cost of debt		5.00%
Debt-to-value ratio (D/V)		0.5
Systematic risk (beta)		1.2
Japanese long-run GDP growth rate	3%
WACC	12.80%

Required:

1. Calculate the cost of capital, in Australia, for the project.   
2. Calculate the forward exchange rates, F₁(AUD/Yen) through F₃(AUD/Yen), for the years 1, 2, and 3 based on the spot rate and the interest rates given in the question. (round to 5 decimal places)   
3. Calculate the Free of Cash Flows of the project in Yen from year 1 to year 3.   
4. What is the terminal value as of year 3? Use a perpetuity formula, the Free Cash Flows in Yen for year 3, and the Japanese growth rate assumption given in the question. Assume the appropriate discount rate is WACC.                              
5. Calculate the AUD value of FCF for the years 0, 1, 2 and 3 and the terminal value   using the forward rates calculated in (b).
6. What is the NPV of the project from XYZ's perceptive (in AUD)? Should XYZ expand into the Asian market?

Answer 1

A]

Cost of equity = risk free rate + (beta * equity risk premium) = 4% + (1.2 * 6%) = 11.2%

Cost of debt = before-tax cost of debt * (1 - tax rate) = 5% * (1 - 30%) = 3.5%

proportion of debt = 0.5 (debt-to-value ratio)

proportion of equity = 1 - proportion of debt = 1 - 0.5 = 0.5

cost of capital = (proportion of debt * cost of debt) + (proportion of equity * cost of equity)

cost of capital = (0.5 * 3.5%) + (0.5 * 11.2%) = 7.35%

B]

F1 = spot rate (AUD/Yen) * (1 + AUD interest rate) / (1 + Yen interest rate) = 0.01 * (1 + 0.04) / (1 + 0.03) = 0.0101

F2 = spot rate (AUD/Yen) * (1 + AUD interest rate)² / (1 + Yen interest rate)² = 0.01 * (1 + 0.04)² / (1 + 0.03)² = 0.0102

F3 = spot rate (AUD/Yen) * (1 + AUD interest rate)³ / (1 + Yen interest rate)³ = 0.01 * (1 + 0.04)³ / (1 + 0.03)³ = 0.01029

C]

profit before tax = EBITDA - depreciation

taxes = 40%

FCF = profit after tax + depreciation - working capital investment - capex

Year	Invesment	EBITDA	WC Investment	Depreciation	Capex	Profit before tax	Taxes	Profit after tax	FCF
0	(80,000,000)		(5,000,000)
1		35,000,000	(5,000,000)	(4,000,000)	(8,000,000)	31,000,000	(12,400,000)	18,600,000	9,600,000
2		45,000,000	(8,000,000)	(4,000,000)	(8,000,000)	41,000,000	(16,400,000)	24,600,000	12,600,000
3		55,000,000	(10,000,000)	(4,000,000)	(8,000,000)	51,000,000	(20,400,000)	30,600,000	16,600,000

D]

Terminal value = (FCF in year 3 * (1 + long-term growth rate)) / (WACC - long-term growth rate)

TV = (16,600,000 * (1 + 0.03)) / (0.1280 - 0.03) = 174,469,388