5 Brighteyes plc manufactures medical and optical equipment for both domestic and export sale. It is investigating the construction of a manufacturing plant in Lastonia, a country in the former Soviet bloc. Initial discussions with the Ministry of Economic Development in Lastonia have met with favourable response, providing the project can generate a 10 per cent pre-tax return. Shareholders look for a return of 15 per cent in real terms.

The investment will be partly import-substituting and partly export-based, selling to neighbouring countries.

The project has been offered a local tax holiday, exempting it from all taxes for the first ten years, except for cash remittances, for which a 20 per cent withholding tax will apply. Modern factory premises on an industrial estate with convenient road and rail links have been offered at a reasonable rent.

The initial investment will be £10 million in plant, machinery and set-up costs, all payable in sterling by the parent company. Additional funds will come from a bank loan of 20 million latts, the local currency 14 latts = £12,negotiated with a local bank, at a concessionary rate of interest of 10 per cent p.a. This will be used to finance working capital. Operating cash flows, the basis for calculating tax, are estimated at L10 million in Year 1 and L22 million thereafter until year 5.

The whole of the parent’s earnings after payment of local interest and taxation will be repatriated to the UK. The Lastonia withholding tax is to be allowed as a deduction before calculating the UK Corporation Tax, currently at the rate of 30 per cent. All transfers can be treated as occurring on the final day of each accounting period, when all taxes become due.

The new venture is expected to ‘cannibalise’ exports that Brighteyes would otherwise have made to neighbouring countries, resulting in post-tax cash flow losses of £0.5 million in each of years 2 to 5. For planning purposes, year 5 is the cut-off year, when the realisable value of the plant and equipment is estimated at L24 million. The working capital will be realised, subject to losses of L2 million on stocks and L2 million on debtors. Funds realised will be used to repay the local borrowing, and the balance transferred to the UK without further tax penalty or restriction.

The exchange rate is forecast to remain at L4 vs. £1 until year 2, when the Latt is expected to fall to L5 vs. £1 Required

(i) Is the project acceptable from the Lastonian Ministry’s point of view?

(ii) Is it worthwhile from the viewpoint of the foreign subsidiary?

(iii) Does it create wealth for Brighteyes’ shareholders?