Reference no: EM131449337

Wolverine Corp. currently has no existing business in New Zealand. But is considering establishing a subsidiary there. The following information has been gathered to assess this project: Initial investment is $50 million in New Zealand dollars (NZ$). Given the existing spot rate of $.50 per New Zealand dollar, the initial investment in US dollars is $25 million. In addition to NZ 50 million initial investment for plant and equipment NZ 20 million is needed for working capital and will be borrowed by the subsidiary by the NZ bank. The NZ and 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 ten 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 NZ are as follows:

1        NZ$500        40,000          NZ$30

2        NZ$511        50,000          NZ$35

3        NZ$530        60,000          NZ$40

The fixed costs, such as overhead expenses are estimated to be NZ6 million per year. The exchange rate of the NZ dollar is expected to be $.52 at the end of Year 1, $.54 at end of Year 2, and $.56 at the end of Year 3.

The NZ government will impose an income tax of 30% on income. In addition, it will impose a withholding tax, of 10% on earning remitted by the subsidiary. The US government will allow a tax credit on the remitted earnings and will not impose 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. Since the plant and equipment are initially valued at NZ$50 million the annual depreciation expense is NZ$5 million.

In three years the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the existing loan. The working capital will not be liquidated. But will be used by the acquiring firm that buys the subsidiary. Wolverine expects to receive NZ$52 million after subtracting capital gain taxes. Assume that this amount is not subject to a withholding tax.

Wolverine requires a 20 percent rate of return on this project.

Determine the net percent of this project. Should Wolverine accept this project?

Assume that Wolverine is also considering an alternative financing arrangement. In which the parent would invest an additional $10 million to cover the working capital requirement so that the subsidiary will not need the NZ loan. If this arrangement is used the selling price of the subsidiary (after subtracting any capital gain taxes) is expected to be NZ$18 million higher. Is this alternative financing arrangement more feasible for the parent than the original proposal? Explain.

e. What is the break-even salvage value of this project? If Wolverine uses the original financing proposal and funds are not blocked.