Question 7.EX.5.5: Foreign direct investment evaluation WK plc is a UK compan...
Foreign direct investment evaluation
WK plc is a UK company which plans to set up a manufacturing subsidiary in the small country of Parland, whose currency is the dollar. An initial investment of $5m in plant and machinery would be needed. Initial investment in working capital of $500,000 would be financed by a loan from a local bank, at an annual interest rate of 10 per cent per year. At the end of five years, the subsidiary would be sold as a going concern for $12m and part of the proceeds would be used to pay off the bank loan.
The subsidiary is expected to produce net cash flows from operations of $3m per year in current price terms over the five-year period, before allowing for Parland inflation of 8 per cent per year. Capital allowances on the initial investment in plant and machinery are available on a straight-line basis at 20 per cent per year. As a result of setting up the subsidiary, WK plc expects to lose after-tax export income from Parland of £80,000 per year in current price terms, before allowing for UK inflation of 3 per cent per year.
Profits in Parland are taxed at a rate of 20 per cent after interest and capital allowances. All after-tax cash profits are remitted to the UK at the end of each year. UK tax of 24 per cent is charged on UK profits, but a tax treaty between Parland and the UK allows tax paid in Parland to be set off against any UK liability. Taxation is paid in the year in which the liability arises. WK plc requires foreign investments to be discounted at 15 per cent. The current exchange rate is $2.50/£1 and the dollar is expected to depreciate against sterling by 5 per cent per year. Should WK plc undertake the investment in Parland?
The calculation of the subsidiary’s cash flows is given in Table 7.5. The net cash flows from operations have been inflated by 8 per cent per year. Note that a separate tax calculation has not been carried out, but instead capital allowances have been deducted from net cash flows from operations to give taxable profit and then added back to after-tax profit to give after-tax cash flows. The capital allowances must be added back because they are not cash flows. Note also that, as the subsidiary is sold as a going concern, working capital is not recovered.
The first step to determining the acceptability of the project to WK plc is to translate the remitted cash flows into sterling. The exchange rates have been increased by 5 per cent each year because the dollar is expected to depreciate against sterling by 5 per cent per year. UK tax payable on the sterling cash flows has been calculated by applying the UK tax rate to the profit before tax of the Parland subsidiary and then
deducting local tax paid, as follows:
This calculation can be repeated for subsequent years, bearing in mind that the exchange rate changes each year. After incorporating the after-tax value of the lost export sales, the parent company cash flows and their present values can be determined, as shown in Table 7.6.
We have:
\begin{aligned}NPV & =-2,000,000+797,000+708,000+628,000+560,000+2,291,000 \\& =£ 2,984,000\end{aligned}At the parent company level, the NPV is strongly positive and so the project should be accepted. The following observations can be made:
■ The evaluation assumes that both sales volume and inflation rates are constant over the five-year period, but in reality these will change due to market forces. Is it possible to forecast these project variables more accurately?
■ The discount rate of 15 per cent must be justified. Has the risk of the project been taken into account in calculating the discount rate?
■ Are there any benefits that are non-financial in nature or that are difficult to quantify which have not been included in the evaluation, for example, the existence of ‘real options’, like the possibility of continuing in production with different products rather than selling the business to a third party?
Table 7.5 Calculation of the project cash flows for WK plc’s subsidiary in Parland
\begin{array}{|c|c|c|c|c|c|c|}\hline \text { Year } & \begin{array}{c}0 \\(\$ 000)\end{array} & \begin{array}{c}1 \\(\$ 000)\end{array} & \begin{array}{c}2 \\(\$ 000)\end{array} & \begin{array}{c}3 \\(\$ 000)\end{array} & \begin{array}{c}4 \\(\$ 000)\end{array} & \begin{array}{c}5 \\(\$ 000)\end{array} \\\hline \begin{array}{l}\text { Cash flows from } \\\text { operations }\end{array} & & 3,240 & 3,499 & 3,779 & 4,081 & 4,408 \\\hline \text { Capital allowances } & & (1,000) & (1,000) & (1,000) & (1,000) & (1,000) \\\hline \text { Interest } & & \underline{(50)} & \underline{(50)} & \underline{(50)} & \underline{(50)}& \underline{(50)} \\\hline \text { Profit before tax } & & 2,190 & 2,449 & 2,729 & 3,031 & 3,358 \\\hline \text { Local tax } & & \underline{(438)} &\underline{ (490)} & \underline{(546)} & \underline{(606)} &\underline{ (672)} \\\hline \text { Profit after tax } & & 1,752 & 1,959 & 2,183 & 2,425 & 2,686 \\\hline \text { Add back CAs } & & \underline{1,000} & \underline{1,000} & \underline{1,000} & \underline{1,000} & \underline{1,000} \\\hline \text { Initial investment } & (5,000) & 2,752 & 2,959 & 3,183 & 3,425 & 3,686 \\\hline \text { Working capital } & (500) & (40) & \text { (43) } & \text { (47) } & \text { (50) } & \text { (54) } \\\hline \text { Loan capital } & 500 & & & & & \text { (500) } \\\hline \text { Sale of subsidiary } & & & & & & 12,000 \\\hline \text { Project cash flows } & (5,000) & 2,712 & 2,916 & 3,136 & 3,375 & 15,132 \\\hline\end{array}Table 7.6 Calculation of the project cash flows and present values for WK plc’s subsidiary at parent company level
\begin{array}{|c|c|c|c|c|c|c|}\hline \text { Year } & 0 & 1 & 2 & 3 & 4 & 5 \\\hline \text { Project cash flows }(\$ 000) & (5,000) & 2,712 & 2,916 & 3,136 & 3,375 & 15,132 \\\hline {\text { Exchange rate }(\$ / £)} & 2.50 & 2.63 & 2.76 & 2.90 & 3.04 & 3.19 \\\hline & (£ 000) & (£ 000) & (£ 000) & (£ 000) & (£ 000) & (£ 000) \\\hline \text { UK cash received } & (2,000) & 1,031 & 1,057 & 1,081 & 1,110 & 4,744 \\\hline {\text { UK tax }} & & \underline{ (33) } & \underline{(36)} & \underline{(38)} & \underline{(40)} & \underline{(42)} \\\hline & (2,000) & 998 & 1,021 & 1,043 & 1,070 & 4,702 \\\hline \text { Lost exports after tax } & & \underline{(82)} & \underline{(85)} & \underline{(88)} & \underline{ (91) } & \underline { (93) } \\\hline \text { Parent cash flows } & (2,000) & 916 & 936 & 955 & 979 & 4,609 \\\hline 15 \% \text { discount factors } & 1.000 & 0.870 & 0.756 & 0.658 & 0.572 & 0.497 \\\hline \text { Present values } & (2,000) & 797 & 708 & 628 & 560 & 2,291 \\\hline\end{array}