Brighton, Ltd. is an old-line confectioner specializing in high-quality chocolates. Through its facilities in the United Kingdom, Brighton manufactures candies that it sells throughout Western Europe and North America (the United States and Canada). With its current manufacturing facilities, Brighton has been unable to supply the U.S. market with more than 225,000 pounds of candy per year. This supply has allowed its sales affiliate, located in Boston, to be able to penetrate the U.S. market no farther west than St. Louis and only as far south as Atlanta. Brighton believes that a separate manufacturing facility located in the United States would allow it to supply the entire U.S. market and Canada (which presently accounts for 65,000 pounds per year).

Brighton currently estimates initial demand in the North American market at 390,000 pounds, with growth at a 5 percent annual rate. A separate manufacturing facility would, obviously, free up the amount currently shipped to the United States and Canada. But Brighton believes that this is only a short-run problem. They believe the economic development taking place in Eastern Europe will allow it to sell there the full amount presently shipped to North America within a period of five years. Accordingly, the lost exports will decline by 20% per year until it becomes zero in year five.

Brighton currently realizes 3.00 per pound on its North American exports. Once the U.S. manufacturing facility is operating, Brighton expects that it will be able to price its product at $7.70 per pound initially. This price would represent an operating profit of $4.40 per pound. Both sales price and operating costs are expected to keep track with the U.S. price level; U.S. inflation is forecast at a rate of 3 percent for the next several years. In the U.K., long-run inflation is expected to be in the 4 to 5 percent range, depending on which economic service one follows. The current spot exchange rate is $1.50 per Pound. Brighton explicitly believes in PPP as the best means to forecast future exchange rates.

The manufacturing facility is expected to cost $7,000,000. Brighton plans to finance this amount by a combination of equity capital and debt. The plant will increase Brightons borrowing capacity by 2,000,000, and it plans to borrow only that amount. The local community in which Brighton has decided to build will provide $1,500,000 of subsidized debt financing for a period of seven years at 7.75 percent. The principal is to be repaid in equal installments over the life of the loan. Brighton plans to raise the remaining debt through a domestic bond issue at 10.75% coupon rate.

Brighton thinks it can place the bonds at par value in the market. Brighton estimates its all-equity cost of capital to be 15 percent in pound terms. The U.S., Internal Revenue Service, will allow Brighton to depreciate the new facility over a seven-year period. After that time the confectionery equipment, which accounts for the bulk of the investment, is expected to have substantial market value.

Brighton does not expect to receive any special tax concessions. Further, because the corporate tax rates in the two countries are the same35 percent in the U.K. and in the United Statestransfer pricing strategies are ruled out. Should Brighton build the new manufacturing plant in the United States?

A. Estimate the PV of Incremental Operational Cash Flows

B. Estimate the value of Depreciation tax shield

C. Estimate the value of the subsidized USD loan in pound terms

D. Estimate the value of interest tax shield of the USD subsidized loan in pound terms

E. Estimate the value of interest tax shield from the Eurobond issue

F. Estimate the APV of the project

Summary of Data:

Spot Rate 1.5

Inflation_US 3.00%

Inflation_UK 4.50%

Total Sales to US (units) 390,000

Expected Growth 5%

Lost Sales (Former Exports-Units) 290,000

Expected growth 5%

Cost of Plant (GBP) (4,666,667)

Cost of Plant (USD) (7,000,000)

Depreciation 1,000,000

Contribution Margin on Sales (USD) 4.4

Contribution Margin on Loss Exports (GBP) 3

Cost of Unlevered Equity (GBP) 15%

Subsidized Loan (USD) 1,500,000

Additional Borrowing Capacity (GBP)

UK Tax 35%

US Tax 35%

Tax Penalty on Repatriation 35%

Trapped Funds in Spain (EURO)

Cost of Debt (USD) 9.50%

Cost of Subsidized Debt (USD) 7.75%

Cost of Debt (GBP) 10.75%

Coupon interest in Eurobond 10.75%

Hint: in the case of Brighton firm and project

capital structures are assumed to be at par; you calim100% of the ITS.