Gulf Company is an Italian based manufacturer of radios. The company’s senior management team has believed for several years that there is an opportunity to increase sales in the domestic market and

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THE INSTITUTE OF FINANCE MANAGEMENT

INSTITUTE OF FINANCE MANAGEMENT CHUO CHA USIMAMIZI WA FEDHA

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AFU 08504: INTERNATIONAL FINANCE

INTERNATIONAL CAPITAL BUDGETING

TUTORIAL QUESTIONS

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TQ1. GULF COMPANY

Gulf Company is an Italian based manufacturer of radios. The company’s senior management team has believed for several years that there is an opportunity to increase sales in the domestic market and wish to set up a manufacturing subsidiary in Tanzania. Setting up the Tanzanian subsidiary would involve construction of a new factory in Dar es Salaam. The initial project cash investment is estimated at Euro 1,000,000 divided as follows:

Fixed assets Euro 900,000

Working capital requirements Euro 100,000

Production and sales are expected to be constant at 20,000 units per annum. The average price per radio is estimated as follows:

Year 1: TZS 55,000

Year 2: TZS 53,000

Year 3: TZS 56,000

Year 4: TZS 59,000

The variable cost ratio is forecast at 30% of the selling price and is expected to remain constant. Annual fixed costs (excluding depreciation), are forecast at TZS 80,000,000. As per agreement between Gulf Company and the authorities in Tanzania, depreciation expenses are not tax allowable. Inflation for each economy in the next four years is expected to be: ITALY 4%, TANZANIA 6%. The cost of capital for the company is 10%. The spot exchange rate is TZS 1400/Euro. Corporate tax in Tanzania is 30%, in Italy 40%. Tax is payable, and allowances are available, one year in arrears. The government of Tanzania is anxious to encourage foreign investment and thus allows overseas investors to repatriate an annual cash dividend equal to that year’s after tax accounting profit. Cash remitted to Italy from the subsidiary is not taxable in Italy. The after tax realizable value of the investment in four years’ time is expected to be approximately TZS 200 million.

Required: Evaluate whether Gulf Company should establish the Tanzanian Subsidiary

TQ2. ARREC INTERNATIONAL CO.

Arrec International Company is a South African Company. The Company is considering establishing a manufacturing unit to produce TV sets in Tanzania which has been the main destination for its exports over the last five years. Setting up of the manufacturing plant will involve an immediate investment outlay SAR 10 million. The plant is expected to have a useful life of 5 years with no salvage value. For taxation purposes, the company has to follow the straight line method of depreciation. To support the investment in Tanzania, an additional working capital of TZS 100,000,000 is needed. Other relevant information on the project follows:

Land TZS8,000,000

Production per annum 1,000 units

Variable cost per unit TZS200,000 of which:

Raw Materials per unit TZS50,000

Labor TZS100,000

Overheads TZS50,000

Other Fixed Costs per annum TZS200,000,000

Selling Price per Unit TZS700,000

The South African is subjected to 40% corporate tax rate in Tanzania and its cost of capital is 20 per cent. The exchange rate between the TZS and SAR has been very volatile due to unstable interest rate policies in the two countries. The current exchange rate between the TZS and the SAR is TZS50/SAR. Interest rates are expected to be as follows in the next five years:

YEAR TANZANIA SOUTH AFRICA

1 5% 6%

2 7% 6%

3 6% 5%

4 8% 6%

5 10% 8%

South Africa imposes no taxes on cash profit remitted from abroad.

REQUIRED:

(a) Assuming that all profits can be repatriated, advise Arrec regarding the financial viability of the proposal.

b) Capital budgeting analysis for a foreign project, like the one proposed by Arrec International Co. above, is considerably more complex than the domestic case i.e. if the company were to invest in its domestic country. Outline the main reasons contributing to increased complexity in evaluating foreign projects.

TQ3.: KIPANGA CORPORATION

Kipanga Corporation currently has no existing business in German but it is considering establishing a subsidiary there. The following information has been gathered to assess this project: The initial investment capital required to start the project would be Euro 50 million to be used to buy plant and equipment. The plant is expected to have a useful life of 10 years and would be depreciated using a straight line method. The project would be terminated at the end of year three, when the subsidiary would be sold. Kipanga expects to receive Euros 35 million when it sells the subsidiary. This would be equal to the book value at the end of year 3. The exchange rate of the Euro is expected to be TShs 0.56 at the end of year 3. However it is estimated that the risk free interest rate in Tanzania is 12% and in German is 10%. The price, demand, and variable cost of the product in German are as follows:-

The fixed costs, such as overhead expenses, are estimated to be Euro 6 million per year. All cash flows received by the subsidiary are to be sent to the parent company at the end of each year. The German government would impose an income tax of 30%. In addition, it would impose a withholding tax of 10% on earnings remitted by the subsidiary. The Tanzanian Government would allow a tax credit on remitted earnings and would not impose any additional taxes. Kipanga requires a 20% rate of return on this project.

REQUIRED: Should Kipanga accept the project or not? Justify your answer. (22 Marks)

(b) Describe the mechanics of international APV method of appraising international investment. Under which circumstances might the APV be a better technique to use than NPV?

TQ 4. UK ENGINEERING COMPANY

Consider the following capital budgeting decision: a UK engineering company has been exporting to Holland for a number of years, and the company is considering establishing an engineering subsidiary in Holland. Suppose the project is expected to generate the following additional cash flows in Euros:

Year 0 1 2 3 4 5

Expected CF -600 400 450 510 575 650

The UK company's cost of capital is 16%, and the risk free rate of interest in the UK, r£ is 8%, and in Holland, reuro is 9%. The current spot exchange rate is £1 = 2Euro.

Required: Calculate the NPV of the project.

TQ5. CENTRALIZED & DECENTRALIZED CAPITAL BUDGETING TECHNIQUES

A US firm is considering an investment in Tanzania, which will cost TZS200 million and is expected to produce an income of TZS30 million in real terms in each of the next 7 years. The firm estimates that the appropriate cost of capital for the project is 8%. Annual interest rates are 9% in Tanzania, 7⅞% in the US, the spot exchange rate is TZS1354.50 per US$, and inflation in Tanzania is expected to average 6% per year. At the end of the seventh year the US firm expects to sell the Tanzanian investment to a local firm for TZS50 million.

REQUIRED:

You have been selected as the firm’s financial analyst and you have been assigned the task of supervising the international capital budgeting analysis. Evaluate and comment on the economic viability of the proposed project using the NPV method applying the following techniques:

• Centralized Capital Budgeting and

• Decentralized Capital Budgeting Techniques)