XYZ Electronics has an alternative method of producing the modified bearings. It has an opportunity to build a small manufacturing facility in a foreign country and build the parts from scratch. Because of lower material and labor costs, the cost to manufacture each bearing from scratch is $50, but annual fixed costs are $25k. The cost for setting up this production method is $100k, all of which is for plant & equipment. It still needs $5k worth of inventory that is recovered at the end of the project. The manufacturing facility and its equipment can be sold for $60,000 in 3 years' time, which is mostly the value of the land. The completed units will have to be shipped home (insured) at a flat rate cost of $5/unit. The quality of the product is expected to be consistent with the domestically produced units and can be sold for $795/unit. The tax rate in the foreign country is 15%. There is no tax treaty so cash flows that are repatriated are subject to the domestic tax rate also. (The foreign country does not have a tax credit for capital investments.) The salvage value quantity is exempt from repatriation taxes. The foreign country also uses straight-line depreciation over 3 years.
The initial investment cost is called in current dollars, but future cash flows are subject to exchange rate risk. This risk is reflected in the needed rate of return by adding 3% to the domestic needed rate of return.
1. Search the economic breakeven quantity of demand. (Where NPV equals zero.)
2. Assume that futures contracts suddenly become available so that exchange rate risk can be eliminated. Find the break-even quantity demanded under this scenario.
3. Is it better to produce domestically or in the foreign country? Describe briefly.
4. In this example, the existence of futures contracts would be classified as what?
5. Declare some of the assumptions of capital budgeting, especially in the context of international financial management.