GZ plc plans to build a factory in the USA for $3.4m. Additional investment in working capital of $500,000 would be needed and this would be financed by a loan from a US bank of $500,000. Annual before-tax cash flows of $1m per year in current price terms would be expected from the sale of goods made in the new factory.
Tax in the USA would be at a concessionary rate of 15 per cent per year for a period of five years, which is also the planning horizon used by GZ plc. The company can claim capital allowances on the investment of $3.4m on a 25 per cent reducing balance basis. Tax in the UK is at an annual rate of 30 per cent per year. A double taxation agreement exists between the two countries and tax liabilities are paid in the year in which they arise in both the USA and the UK. The current exchange rate is $1.70/£ and the US dollar is expected to depreciate against sterling by 5 per cent per year.
GZ plc has a nominal after-tax cost of capital of 15 per cent. Annual inflation in the USA is expected to be 3 per cent per year for the foreseeable future. At the end of its fiveyear planning horizon, GZ plc expects the US factory to have a nominal market value of $5m.
(a) Calculate whether GZ plc should build the factory in the USA.
(b) Calculate and discuss whether $5m is an acceptable estimate of the market value of the factory in five years' time.