Question 18.PP.2: An Indian company is planning to set up a subsidiary in the ......
An Indian company is planning to set up a subsidiary in the USA. The initial project cost is estimated to be US dollar 400 million; working capital requirements are estimated at US dollar 40 million.
The Indian company follows the straight-line method of depreciation.
\, The finance manager of the Indian company estimated data in respect of the project as follows:
(i) variable cost of production and sales $ 25 per unit, (ii) fixed cost per annum are estimated at $ 30 million
(iii) plant will be producing and selling 50 million units at $ 100 per unit and (iv) the expected economic useful life of the plant is 5 years with no salvage value.
\, The subsidiary of the Indian company is subject to 40 per cent corporate tax rate in the USA and the required rate of return of such a project is 12 per cent. The current exchange rate between the two countries is Rs 48/US dollar and the rupee is expected to depreciate by 3 per cent per annum for next five years
\, The subsidiary will be allowed to repatriate 70 per cent of the CFAT every year along with the accumulated arrears of blocked funds at year-end 5, the withholding taxes are 10 per cent. The blocked funds will be invested in the USA money market by the subsidiary, earning 4 per cent (free of tax) per year.
\, Determine the feasibility of having a subsidiary company in the USA, assuming no tax liability in India on earnings received by the parent from the US subsidiary.
Recommendation:
Since the NPV is positive, having a subsidiary in the USA is financially viable for the Indian company.
* Repatriation of blocked funds after withholding taxes
Future value in year 5 of blocked funds of 71.7 million each during t = 1 to 4 years invested at 4 per cent per year = 4.246 × 71.7 million = 304.44 million – 30.44 million withholding tax = 274 million.
(i) Cash \>outflows (t = 0)
| $ 400 million | Cost of plant and machinery |
| 40
|
Working capital requirement |
| 440
|
|
| Rs 21,120 million | Incremental cash outflow in rupees ($ 440 million × Rs 48) |
(ii) Cash\> inflows\> after\> taxes
| 500 million | Sales revenue (5.0 million units × $ 100) | |
| Less costs: | ||
| $ 125 million | Variable cost (5.0 million units × $ 25) | |
| 30 | Fixed cost | |
| 235
|
80
|
Depreciation ($ 400 million/5 year) |
| 265 | Earning before taxes | |
| 106
|
Less taxes (0.40) | |
| 159 | Earning after taxes | |
| 80
|
Add depreciation | |
| 239
|
CFAT (T = 1 – 4) | |
| CFAT in 5th year: | ||
| $ 239 | Operating CFAT | |
| 279 | 40 | Add release of working capital |
| Year | Particulars \quad\qquad\qquad\qquad\qquad\qquad\qquad\qquad\quad |
||||
| 5 | 4 | 3 | 2 | 1 | |
| $ 239 | $ 239 | $ 239 | $ 239 | $ 239 | Operating CFAT |
| –
|
71.7
|
71.7
|
71.7
|
71.7
|
Less\,retention |
| 167.3
|
167.3
|
167.3
|
167.3
|
167.3
|
Repatriation made |
| 23.9 | 16.7 | 16.7 | 16.7 | 16.7 | Less withholding tax |
| 215.1 | 150.6 | 150.6 | 150.6 | 150.6 | Accessible funds to parent |
| 274 | — | — | — | — | Add repatriation of blocked funds* |
| 40 | — | — | — | — | Addrecovery of working capital |
| 55.6451 | 54.0244 | 52.4509 | 50.9232 | 49.44 | Re/$ exchange rate |
| 29,442 | 8,136 | 7,899 | 7,669 | Rs 7,445 | Rupee equivalent |
| 0.567 | 0.636 | 0.712 | 0.797 | 0.893 | PV factor (0.12) |
| 16,694
|
5,174 | 5,624 | 6,112 | 6,648 | Present value |
| 40,252 | Total present value | ||||
| 21,210
|
Less cash outflow | ||||
| Rs 19,042 | Net present value | ||||