Question

Late in 2018, Felix Machine Company (FMC) management was considering expansion of the company’s international business activities. FMC is a South Carolina–based manufacturer of compound machines for use in industrial equipment. FMC’s worldwide market was supplied from subsidiaries in France, Brazil, and Taiwan, as well as from the United States. The company was particularly successful in Asia, mainly due to the high quality of its products, its technical expertise, and excellent after-sale service. This success led corporate management to consider the feasibility of further expansion of its business in the Asian region.

FMC’s Taiwanese subsidiary assembled and distributed machines and had limited manufacturing capability so that it could undertake special adaptations required. The Taiwanese subsidiary had been urging corporate management to expand its manufacturing capacity for several years. However, an alternative scenario appeared more promising. The Indian economy, with its liberalized economic policies, was growing at annual rates much higher than those of many industrialized countries. Further, India had considerably lower labor costs and certain government incentives that were not available in Taiwan. Therefore, FMC’s corporate management chose to first consider India for its Asian expansion and had a 4-year investment project proposal prepared by the chief financial officer’s staff.

The proposal involved establishing a wholly-owned subsidiary in India that would produce machines for the Indian domestic market as well as for export to other Asian countries. The initial equity investment would be $1.5 million, equivalent to 67.5 million Indian rupees (Rs) at the exchange rate of Rs 45 to the U.S. dollar. (Assume that the Indian rupee is freely convertible, and there are no restrictions on transfers of foreign exchange out of India.) An additional Rs 27 million would be raised by borrowing from a commercial bank in India at an interest rate of 10 percent per annum. The principal amount of the bank loan would be payable in full at the end of the fourth year. The combined capital would be sufficient to purchase plant and equipment of $1.8 million and would cover other initial expenditures, including working capital. The cost of equipment installation would be $15,000, with another $5,000 for testing. No additional working capital would be required during the 4-year period. The plant was expected to have a salvage value of Rs 10 million at the end of four years. Straight-line depreciation would be applied to the original cost of the plant.

The firm’s overall marginal after-tax cost of capital was about 12 percent. However, because of the higher risks associated with an Indian venture, FMC decided that a 16 percent discount rate would be applied in evaluating the potential project.

Present value factors at 16 percent are as follows:

Period	Factor
1	0.862
2	0.743
3	0.641
4	0.552

Sales forecasts (in units) are as follows:

   Sales (units)

Year	(Domestic)	(Export)
1	5,000	10,000
2	6,000	12,000
3	7,000	14,000
4	8,000	16,000

The initial selling price of a machine was to be Rs 4,500 for both Indian domestic sales and export sales in the Asian region, and the selling price in both cases was to increase at an annual rate of 10 percent. The exchange rate between the Indian rupee and the U.S. dollar was expected to vary as follows:

January 1, Year 1	Rs 45 per U.S. dollar
December 31, Year 1	Rs 45 per U.S. dollar
December 31, Year 2	Rs 43 per U.S. dollar
December 31, Year 3	Rs 40 per U.S. dollar
December 31, Year 4	Rs 38 per U.S. dollar

The cash expenditure for operating expenses, excluding interest payments, would be Rs 44 million in Year 1. This amount was expected to increase at a rate of 8 percent per year. The Indian subsidiary would be expected to pay a royalty of Rs 20 million to the parent company at the end of each of the four years. In addition, in those years in which the subsidiary generated a profit, it would pay a dividend to FMC equal to 100 percent of net earnings. Through negotiation with the Indian government, the subsidiary would be exempt from Indian corporate income taxes and withholding taxes on payments made to the parent company. Royalties received from the Indian subsidiary would be fully taxable in the United States at the U.S. corporate tax rate of 21 percent. Dividends received from the Indian subsidiary would be exempt from U.S. taxation.

Assuming the project proposal is accepted, FMC expects to be able to sell the Indian subsidiary at the end of the fourth year for its salvage value. FMC also expects to be able to repatriate to the parent the cash balance at the end of Year 4. The cash balance will be equal to the difference between the aggregate amount of cash from operations generated by the subsidiary and the aggregate amount of dividends paid to FMC, after paying back the local bank loan, plus salvage value. The repatriated cash balance will be taxed in the United States at 21 percent only if there is a gain after deducting the cost of the original investment.

Required:

1. Calculate the NPV of the proposed investment in India from both a project and a parent company perspective.

2. Recommend to Felix Machine Company’s corporate management whether or not to accept the proposal.

Answer 1

First we have to calculate the amount of Sales per year

Year	Sales (Units) (Domestic+Export)	Sale Price Per Unit (Rs)	Sales (Rs)
1	15000	4500	67,500,000
2	18000	4950	89,100,000
3	21000	5445	114,345,000
4	24000	5989.50	143,748,000

Now lets calcuate the Net Profit of the Project for NPV calculation

Particulars\Year	1	2	3	4
Sales	67,500,000	89,100,000	114,345,000	143,748,000
Less:Operating Exp (b)	44,000,000	47,520,000	51,321,600	55,427,328
Less: Interest cost (a)	2,700,000	2,700,000	2,700,000	2,700,000
Less: Royalty	20,000,000	20,000,000	20,000,000	20,000,000
Net Profits	800,000	18,880,000	40,323,400	65,620,672

Notes

(a) Calculation of Interest

27,000,000x10%= 2,700,000 per year

(b) Calculation of Operating expenses

Since the operatiing exp are given at Rs 44,000,000 for first year and thereafter it will increase @ 8% per annum

accordingly,

44,000,000x108%= 47,520,000 for 2nd Year and so on

(c) The depreciation has not been used in the above calculation since there are no taxes in India accordingly it will not impact the cash flows for NPV. the above profits will be used as cash flows for NPV calculation.

Now lets calculate the NPV of the Project

Year	Cash Flows (A)	PV Factor @ 16% (B)	Present Value of Cash flows (AxB)
0	(67,500,000)	1	(67,500,000)
1	800,000	0.862	689,600
2	18,880,000	0.743	14,027,840
3	40,323,400	0.641	25,847,299.40
4	48,620,672*	0.552	26,838,610.94

NPV (96,649.66)

* At the end of 4^th year the debt will be repaid also the salvage value Is expected to be Rs 10 million

Accordingly cash flow will be:

Profit                                                     65,620,672

Less: Debts repayment 27,000,000

Add: Salvage Value 10,000,000

Cash Flow 48,620,672

Calculation of NPV of Parent Company

Year	Royalty (Net of Tax) (A)	Dividend    (B)	Cash Repatriation (Net of Tax) (C)	Total Inflow (C)=(A x B)	PV Factor @16%   (D)		Present Value (Rs) (E)=(DxC)	Exchange rate (F)	Present Value(USD) (G)= (E/F)
1	15,800,000	-	-	15,800,000	0.862	13,619,600.00		45	302,657.78
2	15,800,000	905,000	-	16,705,000	0.743	12,411,815.00		43	288,646.86
3	15,800,000	22,348,400	-	38,148,400	0.641	24,453,124.40		40	611,328.11
4	15,800,000	47,645,672	37,725,000**	101,170,672	0.552	55,846,210.94		38	1,469,637.13

Present value of Cash Inflows   2,672,269.88

                                                                                                       

NPV= PV of Cash Inflows-PV of Cash Outflows(Initial Investment)

         =2,672,269.88-1,500,000= 1,172,269.88

** Calculation of Cash Balance & Repatriation

Operating Profit of Year 1                                                                              800,000

Add: Depreciation for remaining 3 years (17,975,000 x 3) 53,925,000

Add: Sale of Plant                                                                                         10,000,000

Less: Loan Repayment 27,000,000                                          

Cash Balance                                                                                 37,725,000

Less: Initial Investment( 1,500,000 X 45)                                                        67,500,000

Net gain/(Loss)                                                                                (29,775,000)

Hence there will not be any tax on repatriated cash. The amount to be repatriated shall be 37,725,000

Notes

Cost of machine(Rs)(USD1.8 million x 45)                                              81,000,000

Cost of Installation & Testing (Rs) (USD20,000 x 45)   900,000           

Total Cost                                                                                81,900,000          

Depreciation

81,900,000-10,000,000 = 17,975,000 per year

4

Profit after Depreciation

Year	1	2	3	4
Profit before Depreciation	800,000	18,880,000	40,323,400	65,620,672
Less: Depreciation	17,975,000	17,975,000	17,975,000	17,975,000
Net Profit/(Loss)*	(17,175,000)	905,000	22,348,400	47,645,672

* 100% of Net Profit shall be paid as dividend.

Conclusion

The Felix Machine company should accept the proposal as there is positive NPV of USD 1,172,269.88 at the end of 4 years from the project hence it Is advisable to accept the proposal.