Question

An Irish firm is thinking of making an investment in Bangalore, India. The initial investment required is Indian Rupees (Rs.) 82 million. This investment is considered a capital cost and will be depreciated using straight line depreciation over 5 years. The company is expected to have sales of 40,000 units per year with each unit selling for Rs 3,200. Costs of production are Rs. 1600 per unit. 50% of this cost is for parent supplied components which will generate a 5% profit margin for the parent company. In addition, the Indian subsidiary will pay licensing fees of 2% of annual revenues. The Indian subsidiary will remit dividends of 50% of net income. The remainder of net income will cumulate with the Indian subsidiary and will be remitted back to parent company at the end of 5 years when the Irish firm will exit the venture after selling the Indian subsidiary to the Indian government for Rs. 50 million. Inflation is expected to be 8% per year in India and 4% per year in Ireland. The current exchange rate is Rs. 83 per Euro. The corporate tax rate is 12.5% in Ireland and 35% in India. Assume that all income repatriated to parent is taxed in Ireland at the Irish tax rate. Cost of capital is assumed to be 20% for both parent and subsidiary. Use the information provided above to estimate relevant cash flows and use them for your investment analysis. Highlight any assumptions made. Should the Irish firm make this investment? Make a case to support your decision.

Answer 1

Spot rate, S₀ = Rs. 83 / Euro

i_India = 8%; i_Ireland = 4%

Exchange rate in the year n = S = S₀ x (1 + i_India)ⁿ / (1 + i_Ireland)ⁿ = 83 x (1.08 / 1.04)ⁿ

Hence, Exchange rate in the year 1 = S₁ =83 x 1.08 / 1.04 = R. 86.19 / Euro; Exchange rate in the year 2 = S₂ =83 x 1.08²/ 1.04² = R. 86.19 / Euro and so on...

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are first in Rs. and then in Euro. Adjacent cells in blue contain the formula in excel I have used to get the final output.

Thus, the project has a negative NPV for the parent in terms of Euro. Hence, the Irish firm should not make this investment