$27.$ Capital Budgeting Analysis. 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:

$$ The initial investment required is $$50$ million

in New Zealand dollars $($NZ$$).$ Given the existing spot rate of $$\mathrm{.}50$ per New Zealand dollar, the

initial investment in U$.$S$.$ dollars is $$25$ million.

In addition to the NZ$$50$ million initial investment for plant and equipment, NZ$$20$ million is

needed for working capital and will be borrowed

by the subsidiary from a New Zealand bank. The

New Zealand 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 $10$ 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 New Zealand are as follows:

Year Price Demand Variable Cost

$1$ NZ$$50040,000$ units NZ$$30$

$2$ NZ$$51150,000$ units NZ$$35$

$3$ NZ$$53060,000$ units NZ$$40$

$$ The fi xed costs, such as overhead expenses, are

estimated to be NZ$$6$ million per year.$$ The exchange rate of the New Zealand dollar is

expected to be $$\mathrm{.}52$ at the end of Year $1,$ $$\mathrm{.}54$ at

the end of Year $2,$ and $$\mathrm{.}56$ at the end of Year $3.$

$$ The New Zealand government will impose an income tax of $30$ percent on income. In addition,

it will impose a withholding tax of $10$ percent on

earnings remitted by the subsidiary. The U$.$S$.$

government will allow a tax credit on the remitted

earnings and will not impose any additional taxes.

$$ All cash fl ows 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 $3$ years, the subsidiary is to be sold. Wolverine

plans to let the acquiring fi rm assume the existing New Zealand loan. The working capital will

not be liquidated but will be used by the acquiring fi rm that buys the subsidiary. Wolverine expects to receive NZ$$52$ million after subtracting

capital gains taxes. Assume that this amount is

not subject to a withholding tax.

$$ Wolverine requires a $20$ percent rate of return on

this project.

a$.$ Determine the net present value of this project.

Should Wolverine accept this project?

b$.$ Assume that Wolverine is also considering an alternative fi nancing arrangement, in which the parent would invest an additional $$10$ million to cover

the working capital requirements so that the subsidiary would avoid the New Zealand loan. If this

arrangement is used, the selling price of the subsidiary $($after subtracting any capital gains taxes$)$ is

expected to be NZ$$18$ million higher. Is this alternative fi nancing arrangement more feasible for the

parent than the original proposal? Explain.

c$.$ From the parent$$s perspective, would the NPV

of this project be more sensitive to exchange rate

movements if the subsidiary uses New Zealand fi $-$

nancing to cover the working capital or if the parent invests more of its own funds to cover the

working capital? Explain.

d$.$ Assume Wolverine used the original fi nancing

proposal and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of $6$ percent $($after taxes$)$ until the

end of Year $3.$ How is the project$$s NPV affected?

e$.$ What is the break$-$even salvage value of this project if Wolverine uses the original fi nancing proposal and funds are not blocked?f$.$ Assume that Wolverine decides to implement the

project, using the original fi nancing proposal. Also

assume that after one year, a New Zealand fi rm offers Wolverine a price of $$27$ million after taxes for

the subsidiary and that Wolverine$$s original forecasts for Years $2$ and $3$ have not changed. Compare the present value of the expected cash fl ows if

Wolverine keeps the subsidiary to the selling price.

Should Wolverine divest the subsidiary? Explain.