(a) Evaluate and discuss whether Cargo should undertake the investment in Bulgaria. Relevant calculations must be included. [42 marks]
(b) Cargo has a holding company subsidiary in British Virgin Islands. Discuss how this holding company might be used to reduce tax on dividends remitted from the proposed overseas subsidiary in Bulgaria. [8 marks]
internal/7807/N13313E1-19.pdf?sequence=3&isAllowed=y 1. Cargo Inc., a USA based company, is considering foreign direct investment in Bulgaria. The investment will require 9 million Bulgarian Lev to purchase an existing factory, payable immediately. The factory will need to be modernised prior to production commencing, at an expected cost of 4 million lev, payable in one year's time. New machinery would be supplied from the US parent company at a cost to the Bulgarian subsidiary of $2.9 million, payable in one year. $0.8 million of this sum represents a pre-tax profit to the US parent company. Initial working capital of 3 million Bulgarian lev will be required when production commences in one year's time. Production and sales are expected to be 500,000 units per year, at an initial unit price in the first year of production of 35 Bulgarian lev. Prices are expected to increase by the level of inflation in Bulgaria. Costs are expected to vary as shown below: Unit Cost in first year of operation (TL) 8 Labour Materials 7 Expected change per year Bulgarian inflation 1% Bulgarian inflation + 3% Bulgarian inflation - 5% Bulgarian inflation Distribution 2 Allocated overhead In addition to these local currency costs an essential component will be imported from the US parent company; the cost to the Bulgarian subsidiary will be a constant $1 per unit. The cost to Cargo of producing the component is 70 cents per unit. Cargo currently exports to Bulgaria, and it is believed that pre-tax net cash flow from exports will be reduced by $350,000 per year if the Bulgarian investment takes place. The proposed investment would be financed entirely by a 7 year 6% fixed rate dollar bank loan. This would increase Cargo group's gearing to 60% equity, 40% debt by market value and 50% equity, 50% debt by book value. The investment is expected to have an equity beta 40% higher than Cargo's current equity beta of 1.2. The relevant market return is 9% and risk free rate 4%. Tax allowable depreciation is available on machinery in Bulgaria at a rate of 20% per year on a straight line basis. The corporate tax rate in Bulgaria is 25%, and in the USA 35%. A bilateral tax treaty exists between Bulgaria and the USA. The USA uses a 'worldwide taxation system. Cargo plc has a planning horizon of 4 years of operations. The after tax value of the Bulgarian subsidiary after 4 years is estimated to be 12 million Lev. 1.9370 - 1.9410 Forecast inflation rates USA Bulgaria Year 1 3% 10% 2 3% 10% 3 3% 10% 4 3% 10% 5 10% 3% Assume that Cargo intends to remit the maximum annual cash flow possible to the USA in the form of dividends. Required (a) Evaluate and discuss whether Cargo should undertake the investment in Bulgaria. Relevant calculations must be included. [42 marks] (b) Cargo has a holding company subsidiary in British Virgin Islands. Discuss how this holding company might be used to reduce tax on dividends remitted from the proposed overseas subsidiary in Bulgaria. [8 marks] [Total 50 marks] internal/7807/N13313E1-19.pdf?sequence=3&isAllowed=y 1. Cargo Inc., a USA based company, is considering foreign direct investment in Bulgaria. The investment will require 9 million Bulgarian Lev to purchase an existing factory, payable immediately. The factory will need to be modernised prior to production commencing, at an expected cost of 4 million lev, payable in one year's time. New machinery would be supplied from the US parent company at a cost to the Bulgarian subsidiary of $2.9 million, payable in one year. $0.8 million of this sum represents a pre-tax profit to the US parent company. Initial working capital of 3 million Bulgarian lev will be required when production commences in one year's time. Production and sales are expected to be 500,000 units per year, at an initial unit price in the first year of production of 35 Bulgarian lev. Prices are expected to increase by the level of inflation in Bulgaria. Costs are expected to vary as shown below: Unit Cost in first year of operation (TL) 8 Labour Materials 7 Expected change per year Bulgarian inflation 1% Bulgarian inflation + 3% Bulgarian inflation - 5% Bulgarian inflation Distribution 2 Allocated overhead In addition to these local currency costs an essential component will be imported from the US parent company; the cost to the Bulgarian subsidiary will be a constant $1 per unit. The cost to Cargo of producing the component is 70 cents per unit. Cargo currently exports to Bulgaria, and it is believed that pre-tax net cash flow from exports will be reduced by $350,000 per year if the Bulgarian investment takes place. The proposed investment would be financed entirely by a 7 year 6% fixed rate dollar bank loan. This would increase Cargo group's gearing to 60% equity, 40% debt by market value and 50% equity, 50% debt by book value. The investment is expected to have an equity beta 40% higher than Cargo's current equity beta of 1.2. The relevant market return is 9% and risk free rate 4%. Tax allowable depreciation is available on machinery in Bulgaria at a rate of 20% per year on a straight line basis. The corporate tax rate in Bulgaria is 25%, and in the USA 35%. A bilateral tax treaty exists between Bulgaria and the USA. The USA uses a 'worldwide taxation system. Cargo plc has a planning horizon of 4 years of operations. The after tax value of the Bulgarian subsidiary after 4 years is estimated to be 12 million Lev. 1.9370 - 1.9410 Forecast inflation rates USA Bulgaria Year 1 3% 10% 2 3% 10% 3 3% 10% 4 3% 10% 5 10% 3% Assume that Cargo intends to remit the maximum annual cash flow possible to the USA in the form of dividends. Required (a) Evaluate and discuss whether Cargo should undertake the investment in Bulgaria. Relevant calculations must be included. [42 marks] (b) Cargo has a holding company subsidiary in British Virgin Islands. Discuss how this holding company might be used to reduce tax on dividends remitted from the proposed overseas subsidiary in Bulgaria. [8 marks] [Total 50 marks]
