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An Irish company has an investment in UK and is worried about how the Euro value of this investment might be affected by Brexit. It currently sells 200,000 units per year but expect this to fall by 20% (assume the falls happens immediately and then the lower level of sales are generated every year for the next five years. The company expects to increase its unit price from £20 per unit to £22 immediately and maintain it over the foreseeable future.
Production costs are currently £15 of which £8 are for parent supplied components on which the parent generates a 5% profit margin. These costs are expected to increase to £18 (due to increased costs of imported components). The parent will continue to charge £8 for the components it is supplying but this will mean a reduction in the profit margin to the parent from 5% to 3.5%.
In addition, the UK subsidiary will continue to pay 3% of sales revenues as licensing fees to parent company and will remit dividends equaling 70% of net income to the parent company each year. Terminal value in year 5 is expected was expected to be £2.5 million when the Irish company exits this investment by selling it to a third-party. However, due to the increased uncertainty about economic conditions in UK, the Irish company has decided to use a terminal value of £1.8 million in order to value the venture more conservatively.
The expected inflation in Ireland is 4% per annum while the expected inflation in the UK is 5% per annum. The current exchange rate is £1.28 per €. Corporate tax rate is 12.5% in Ireland and 35% in US. Cost of capital is assumed to be 18% for both parent and subsidiary. Use the information provided above to estimate relevant cash flows and use them to estimate the change in the value of the UK subsidiary to the parent firm.
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