A Joint Venture in Pakistan

International Capital Budgeting

It is the end of the year, and Agway, Inc., a US company, has been approached by Lakson Group, a company from Pakistan, to explore the possibility of a joint venture in Pakistan to produce widgets. This year, Agway exported 100,000 widgets to Pakistani importer SS Import-Export Co. at 5,000 Pakistan rupees (PKR) each. The spot exchange rate is 100 PKR per $1. Each widget costs Agway $30 to produce and ship to Pakistan. Agway estimates that from now on widget sales in Pakistan will increase at a 5% annual rate.

Production of widgets in Pakistan requires the construction of a plant which, at the prevailing spot exchange rate, has an immediate cost of $6,000,000 to be equally shared by the two firms. The plant could be depreciated on a straight-line basis over 8 years. In addition, it is estimated that at the prevailing spot exchange rate each partner must contribute $500,000 of net working capital right away to launch the joint venture. The total cost of production in Pakistan is currently estimated to be 2300 PKR per widget and is expected to remain unchanged over the following five years. Part of this cost is for components produced by Agway in the US, at a cost of $5, and then supplied to the joint venture plant in Pakistan at $7 per widget. SS Import-Export has agreed to buy the widgets produced in Pakistan over the next five years at the same price it currently pays to import them from the US. The applicable tax rate in Pakistan, and in the US, is 35%.

Five years after the joint venture is established, Agway will pull out and in return it will recover in full its investment in net working capital and it will also sell its share of the plant to Lakson for an amount equal to 110% of its share of the plants book value at that time. To promote investment by US firms in Pakistan, the US government has agreed that the sale of Agways share of the plant to Lakson five years from now has no tax implications. In addition, the Pakistani government has agreed that at the end of each of the next five years Agway may remit its share of the joint ventures net cash flows to the US at the prevailing exchange rate.

You are in charge of evaluating the joint venture for Agway. You believe that projects similar to that in the joint venture would require a 12% rate of return if undertaken in the US. Further, your assistant has provided the following input about the projected inflation rates over the next five years:

Year	1	2	3	4	5
US	1%	1%	2%	2%	2%
Pakistan	3%	4%	6%	6%	6%

1. What would be your recommendation to Agway? Make sure you provide calculations using the foreign country approach and the home country approach and explain to the management of the two partner firms what the dollar denominated NPV of the joint venture to Agway is under each of these two approaches. (Note: To enable comparisons across students, please explain in detail your calculations for t = 2, as well as for any special, one time, items you encounter at t = 0 and t = 5 in your analysis.