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 $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million.

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$500 40,000 units NZ$30

2 NZ$511 50,000 units NZ$35

3 NZ$530 60,000 units NZ$40

The fixed 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 the same as the current spot rate in next 3 years.

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 flows received by the subsidiary are to be sent to the parent at the end of each year.

The plant and equipment are depreciated over 10 years using the straightline depreciation method. Since the plant and equipment are initially valued at NZ$50 million, the annual depreciation expense is NZ$5 million.

In three years, the subsidiary is to be sold. 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.

1)Determine the net present value and IRR of this project. Should Wolverine accept this project?

Please discuss the impact of a stronger NZD on the NPV of the project. How would your answer change if New Zealand dollar appreciates by 3% every year? Please discuss the impact of a weaker NZD on the NPV and IRR of the project. How would your answer change if New Zealand dollar depreciates by 3% every year?

2)In order to reduce the exchange rate exposure, Wolverine uses forward contract to hedge NZD 6,000,000 every year. The one-year, two-year, and three-year forward rate are $0.48, $0.47, and $0.46, respectively. What are the new NPV and IRR? Assume New Zealand dollar depreciates by 3% every year in next 3 years. Compare your answer in (b), how does Wolverine benefit from hedging?

3)Assume 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 are the project NPV and IRR affected? Assume the exchange rate of the New Zealand dollar to be the same as the current spot rate in next 3 years.

4)Assume the new project reduce the parents prevailing cash flows by $1,000,000 every year, what are the new NPV and IRR? Assume the exchange rate of the New Zealand dollar to be the same as the current spot rate in next 3 years.