Reference no: EM133061738

1. XYZ co., Ltd. Is considering to establish a subsidiary in New Zealand. The following information has been gathered to assess this project:

• The initial investment required is NZ$50 million (NZ$ is New Zealand dollars). Given the existing spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20 million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 14 percent. The loan principal is to be paid in 10 years.
• The project will be terminated at the end of Year 3, when the subsidiary will be sold.
• The price, demand, and variable cost of the product in New Zealand are as follows:

Year      Price           Demand         Variable Cost 

1            NZ$500     40,000 units        NZ$30 

2           NZ$511        50,000 units        NZ$35 

3           NZ$530      60,000 units        NZ$40

• The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
• The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at the end of Year 2, and $.56 at the end of Year 3.
• The New Zealand government will impose an income tax of 30 percent on income. In addition, it will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes.
• All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations.
• The plant and equipment are depreciated over 10 years using the straight-line depreciation method.
• In three years, the subsidiary is to be sold. XYZ plans to let the acquiring firm assume the existing New Zealand loan. The working capital will not be liquidated but will be used by the acquiring firm when it sells the subsidiary. XYZ expects to receive NZ$52 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
• XYZ requires a 20 percent rate of return on this project. 
• Determine the net present value of this project. Should XYZ accept this project?

2. From problem 1, assume that XYZ is also considering an alternative financing arrangement, in which the parent would invest an additional $10 million to cover the working capital requirements so that the subsidiary would not need the New Zealand loan. If this arrangement is used, the selling price of the subsidiary (after subtracting any capital gains taxes) or salvage value is expected to be NZ$18 million higher. Is this alternative financing arrangement more feasible for the parent than the original proposal? Explain. 

3. From XYZ Corporation case in problem 1, from the parent's perspective, would the NPV of this project be more sensitive to exchange rate movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent invests more of its own funds to cover the working capital? Explain. 

4. From problem 1, what is the break-even salvage value of this project if XYZ uses the original financing proposal and funds are not blocked? 

5. From problem 1, assume XYZ used the original financing proposal and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the end of Year 3. How is the project's NPV affected? 

6. From problem 1, assume that XYZ decides to implement the project, using the original financing proposal. Also assume that after one year, a New Zealand firm offers XYZ a price of $27 million after taxes for the subsidiary and that XYZ's original forecasts for Years 2 and 3 have not changed. Compare the present value of the expected cash flows it XYZ keeps the subsidiary to the selling price. Should XYZ divest the subsidiary? Explain.

7) From problem 1, XYZ recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount of NZ$5,000,000 it will receive with a forward contract and hedging the additional amount it might receive with a put option on NZ$. The one-year put option has an exercise price of $.55and a premium of $.01. Determine the NPV if XYZ uses this strategy.