Case 1: International Capital Budgeting Case

Blooming Blueberries Inc. is a privately owned blueberry production company in Richmond, BC. The company has been in business since 1984, and is managed by owner-manager Mr. Larry Daly and his son, Mr. Barry Daly. The company produces blueberries and wholesales most of its product in Canada. Two years ago (2012), Larry connected with a Bruneian businessman, who acted as a middleman for Blooming Blueberries, to export and distribute blueberries in Brunei. The company has been exporting 100,000 pounds of blueberries to Brunei each year for the past two years. Due to a recently published scientific study that showed that people who eat at least one pound of blueberries a week live longer and healthier, the demand for blueberries worldwide is expected to increase dramatically. In Brunei, demand for the companys blueberries is anticipated to increase to 300,000 pounds next year, with expected growth of 5% percent per year for the next five years.

Larry is considering building a distribution centre in Brunei to handle the increased demand. The Bruneian middleman is presently taking a 50% cut on the revenues from the sales of blueberries in Brunei. By eliminating the middleman, Larry thinks that he will be able to make a higher profit.

The company recently reached a tentative agreement (called a memorandum of understanding) with the Brunei government, allowing it to build a facility in Brunei to receive and distribute its products for the next six years. The plant and equipment will cost 2 million Brunei dollars. Fixed costs are estimated to be 200,000 Brunei dollars per year, and variable costs (including labour and materials) are estimated to be 1 Brunei dollar per pound. Shipping of the product will cost about $100,000 Canadian per year. The plant and equipment can be depreciated over a 10-year period on a straight-line basis. At the end of the sixth year, the fixed assets can be sold for an estimated $860,000, with any depreciation recapture taxable at 30%. The corporate tax rate in both countries is 30%. The project will also require an investment of net working capital of $250,000 Canadian at the start of the project, which will be recovered at the end of the sixth year. The weighted average cost of capital for Blooming Blueberries is around 16%. The company can borrow funds from its bank at an interest rate of 8%.

Barry Daly, Larrys son, has a masters degree in finance from the Canadian Agricultural University. Barry advised Larry that the changes in the exchange rate may make or break this project. Larry asked Barry to help find out more about the Canadian-Brunei exchange rates. Barry knows that the future spot exchange rates between the two countries can be estimated using the Relative Purchasing Power Parity (RPPP) formula:

E[St] = E[St-1] [1 + (hFC,t hDOM,t)]

where

E[St] = Projected exchange rate at time t

E[St-1] = Projected exchange rate at time t-1, one period before time t

hFC,t = Projected inflation rate in foreign country at time t

hDOM,t = Projected domestic inflation rate at time t

For example,

E[S1] = E[S0] [1 + (hFC,1 hDOM,1)]

E[S2] = E[S1] [1 + (hFC,2 hDOM,2)]

In Year 2, the projected exchange rate from last year, E[S1] and the foreign and domestic inflation rates for Year 2 are used to derive the new projected exchange rate for Year 2.

Barry gathered the following information from the Internet:

Current spot rate: $1 Canadian = $1.15 Bruneian

Government of Canada 1-year Treasury Bill rate = 1% per annum (effective)

Estimated Inflation rates:

Year	Canada	Brunei
2015	1.8%	1.0%
2016	1.8%	1.0%
2017	1.7%	1.0%
2018	1.7%	1.0%
2019	1.6%	0.9%
2020	1.8%	0.9%

The current wholesale price of blueberries in Brunei is 5 Brunei dollars per pound, and this price is expected to increase at the same rate as the Bruneian inflation rate. Variable costs are also expected to increase at the Bruneian inflation rate. Fixed costs and shipping cost are expected to remain the same for the next six years.

Before deciding whether to invest in this project, Larry needs answers to the following questions:

1. What is the NPV of the project? Barry suggests the use of the Home Currency Approach. (20 marks)

2. What other risk factors (besides exchange rate risk) should the company consider before investing in the project? Search The Straits Times (from Singapore) for news on Brunei, and identify one major issue that the company may face, other than exchange rate risk, that could sway Larry one way or the other regarding investing in Brunei. (5 marks)

3. If the company is able to borrow the 1 million Brunei dollars capital from a local bank in Brunei at 10%, will it make a difference whether it borrows the money in Canada or in Brunei? Barry says no, according to the Uncovered Interest Parity and Generalized Fisher Effect relationships between exchange rates and interest rates. Explain why this is so. (5 marks)

4. Based on all the above analyses, should the company invest in this distribution centre in Brunei? (5 marks)