North Star Company, a U.S. based MNC, is considering to establish a subsidiary to capitalize on the removal of Eastern European border restrictions. The subsidiary would manufacture clothing in Germany and target the Eastern European countries for most of its business. Its sales would be invoiced in EUR. It has forecasted net cash flows to the subsidiary as follows:
|
Year
|
Net Cash Flows to Subsidiary
|
|
1
|
EUR 4,000,000
|
|
2
|
5,000,000
|
|
3
|
5,000,000
|
|
4
|
6,000,000
|
|
5
|
8,000,000
|
|
6
|
8,000,000
|
These cash flows do not include financing costs (interest expenses) on any funds borrowed in Germany. North Star Company also expects to receive EUR15,000,000 after taxes as a result of selling the subsidiary at the end of Year 6. Assume that there will not be any withholding taxes imposed on this amount.
The exchange rate of the EUR is forecasted as follows based on three possible scenarios of economic conditions:
|
End of Year
|
Scenario I:
Somewhat Stable EUR
|
Scenario II:
Weak EUR
|
Scenario III: Strong EUR
|
|
1
|
1.4000
|
1.3900
|
1.4200
|
|
2
|
1.4100
|
1.3600
|
1.4500
|
|
3
|
1.3800
|
1.3500
|
1.4900
|
|
4
|
1.4000
|
1.3300
|
1.5400
|
|
5
|
1.4200
|
1.3300
|
1.5700
|
|
6
|
1.3800
|
1.3100
|
1.6100
|
The probability of each scenario is shown below:
|
Somewhat Stable EUR
|
Weak EUR
|
Strong EUR
|
|
Probability
|
60%
|
30%
|
10%
|
|
|
|
|
|
|
Fifty percent of the net cash flows to the subsidiary would be remitted to the parent, while the remaining 50% would be reinvested to support ongoing operations at the subsidiary. North Star Company anticipates a 10% withholding tax on funds remitted to the United States.
The initial investment (including investment in working capital) by North Star in the subsidiary would be EUR20,000,000. Any investment in working capital (such as accounts receivable, inventory, etc.) is to be assumed by the buyer in Year 6. The expected salvage value has already accounted for this transfer of working capital to the buyer in Year 6. The initial investment could be financed completely by the parent (USD28,000,000, converted at the present exchange rate of USD1.4000/EUR to achieve EUR20,000,000). North Star Company will only go forward with its intentions to build the subsidiary if it expects to achieve a return on its capital of 18% or more.
The parent is considering an alternative financing arrangement. With this arrangement, the parent would provide USD14,000,000 (EUR10,000,000), which means that the subsidiary would need to borrow EUR10,000,000. Under this scenario, the subsidiary would obtain a 20-year loan and pay interest on the loan each year. The interest payments are EUR980,000 per year. In addition, the forecasted proceeds to be received from selling the subsidiary (after taxes) at the end of six years would be EUR10,000,000 (the forecast of proceeds is revised downward here because the equity investment of the subsidiary is less; the buyer would be assuming more debt if part of the initial investment in the subsidiary were supported by local bank loans). Assume the parent's required rate of return would still be 18%.
1. Which of the two financing arrangements would you recommend to the parent? Assess the forecasted NPV for each exchange rate scenario to compare the two financing arrangements and substantiate your recommendation.
2. In the first question, an alternative financing arrangement of partial financing by the subsidiary was considered, with an assumption that the required rate of return by the parent would not be affected. Is there any reason why the parent's required rate of return might increase when using this financing arrangement? Explain. How would you revise the analysis in the previous question under this situation? (This question requires discussion, not analysis.)
3. Would you recommend that North Star Company establish the subsidiary even if the withholding tax is 20%?
4. Assume that there is some concern about the economic conditions in Germany which could cause a reduction in the net cash flows to the subsidiary. Explain how Excel could be used to reevaluate the project based on alternative cash flow scenarios. That is, how can this form of country risk be incorporated into the capital budgeting decision? (This question requires discussion, not analysis.)
5. Assume that North Star Company does implement the project, investing USD14,000,000 of its own funds with the remainder borrowed by the subsidiary. Two years later, a U.S.-based MNC, notifies North Star that it would like to purchase the subsidiary. Assume that the exchange rate forecasts for the somewhat stable scenario are appropriate for Years 3 through 6. Also assume that the other information already provided on net cash flows, financing costs, the 10% withholding tax, the salvage value, and the parent's required rate of return is still appropriate. What would be the minimum USD price (after taxes) that North Star should receive to divest the subsidiary? Substantiate your opinion