Reference no: EM132021312

Pretty Face is an American company that produces body care products. Founded in 1948, the company has grown from a small family business to a medium-sized corporation (around 400 employees), with more than 50 stores spread all over the United States. The company is contemplating establishing a subsidiary in Brazil, the first step in becoming a leading brand in South America. The subsidiary will initially operate for a period of five years, with a decision by Pretty Face of whether or not to carry on with the foreign business to be made later on during the project’s lifetime. Pretty Face’s required rate of return is 8%, and the development of the subsidiary requires an initial investment of BRL$60 million (BRL – Brazilian real – is the country’s currency): 60% is to be allocated to the construction of facilities, 30% to the purchase of machines, and 10% to working capital. At this stage, the only product to be marketed in Brazil will be Pretty Face’s flagship brand Sunnies, a sunscreen that the company expects to sell at a price of BRL$18 per unit (i.e. to be adjusted annually as per the inflation rate, forecasted at 6% per year), with an estimated demand of 1,400,000 units per year (i.e. assumed to be stable during the project’s lifetime). The variable costs associated with the production of the sunscreen are mainly due to labour and materials, amounting to BRL$8 per unit, with fixed costs being mainly overhead expenses of BRL$2,000,000 per year. The only factor causing future changes in both variable and fixed costs is the inflation rate. Tax laws in Brazil allow for the total cost of facilities and machines to be fully depreciated (i.e. zero book value) by the end of year 5, in amounts equally spread across the project’s lifetime. Although the machines to be employed in the production of the sunscreen will have zero salvage value, at the end of the project the facilities built could be sold at an estimated price of BRL$43.2 million (i.e. the commercial real estate sector is booming in Brazil, with no signs of waning in the foreseeable future). Although Brazil imposes a corporate tax rate of 25% on income, there are neither capital gain taxes nor restrictions or taxes on funds to be sent to Pretty Face in the United States. Required: Based on this information, write a report addressing the following:

Presenting your calculations in a table format, indicate the annual cash flows in BRL that the subsidiary of Pretty Face expects to remit to the United States during the project’s lifetime.

The spot rate of the Brazilian real is being quoted at USD$0.30, the same that the company expects to prevail in the next 5 years (i.e. before accounting for inflation). Moreover, the forward rate is currently quoted at USD$0.30 for years 1 and 2, USD$0.27 for years 3 and 4, and USD$0.25 for year 5. Calculate the annual cash flows (i.e. in USD) that Pretty Face will receive if (i) its subsidiary hedges BRL$20 million annually during the project’s lifetime, and (ii) no revenue is hedged. What is the net present value (NPV) associated with the investment in the subsidiary following the hedging and non-hedging strategies? Which one would you suggest to use? Pretty Face is contemplating a different financial arrangement to establish its subsidiary in Brazil. Particularly, the company wants to use its own funds to finance 30% of the initial investment, with the remaining 70% to be obtained by issuing debt. The question is whether the company should issue the debt in the United States or rather in Brazil: in the former, Pretty Face could borrow at an annual rate of 3%, whereas in the later at a rate of 7% (i.e. both loans involve annual interest payments from years 1 to 5, plus a principal payment in year 5). What would be the best option for Pretty Face, i.e. the one that would maximise the NPV of the project? Another option for Pretty Face would be to issue new shares to finance the investment in the Brazilian subsidiary. Based on the capital asset pricing model (CAPM), provide an estimate of what the cost of equity would be if shares were issued in United States, and similarly if shares were issued in Brazil. Elaborate on the factors driving the difference between the two. Before approving the project, the board of directors at Pretty Face asks what would be the consequences for its subsidiary in case halfway through the project (e.g. year 3) the world finds itself engulfed in a crisis of the magnitude of the GFC of 2007–2009. Answer the question raised by the board by way of explaining how you expect the demand for sunscreens in Brazil and the exchange rate BRL/USD to be affected, and how a potential shortage of funds at the subsidiary could be overcome. Assessment Submission