Case 13-1 Canyon Power Company Late in 2009, Canyon Power Company (CPC) management was considering expan- sion of the companys international business activities. CPC is an Arizona-based manufacturer of specialist electric motors for use in industrial equipment. All of the companys sales were to other manufacturers in the industrial equipment indus- try. CPCs worldwide market was supplied from subsidiaries in Germany, Mexico, and Malaysia as well as the United States. The company was particularly success- ful in Asia, mainly due to the high quality of its products, its technical expertise, excellent after-sale service, and of course the continued rapid economic growth in many Asian countries. This success led corporate management to consider seri- ously the feasibility of further expansion of its business in the Asian region. The Malaysian subsidiary of CPC distributed and assembled electric motors. It also had limited manufacturing facilities so that it could undertake special adapta- tions required. With the maturing of the Asian market, particularly in the industrial

sector, an expansion of capacity in that market was of strategic importance. The Malaysian subsidiary had been urging corporate management to expand its ca- pacity since the beginning of 2009. However, an alternative scenario appeared more promising. The Indian economy, with its liberalized economic policies, was growing at annual rates much higher than those of many industrialized countries. Further, India had considerably lower labor costs and certain government incen- tives that were not available in Malaysia. Therefore, the company chose India for its Asian expansion project, and had a four-year investment project proposal prepared by the treasurers staff. The proposal was to establish a wholly owned subsidiary in India produc- ing electric motors for the Indian domestic market as well as for export to other Asian countries. The initial equity investment would be $1.5 million, equivalent to 67.5 million Indian rupees (Rs) at the exchange rate of Rs 45 to the U.S. dol- lar. (Assume that the Indian rupee is freely convertible, and there are no restric- tions on transfers of foreign exchange out of India.) An additional Rs 27 million would be raised by borrowing from a commercial bank in India at an interest rate of 10 percent per annum. The principal amount of the bank loan would be payable in full at the end of the fourth year. The combined capital would be suf- ficient to purchase plant of $1.8 million and would cover other initial expendi- tures, including working capital. The cost of installation would be $15,000, with another $5,000 for testing. No additional working capital would be required during the four-year period. The plant was expected to have a salvage value of Rs 10 million at the end of four years. Straight-line depreciation would be applied to the original cost of the plant. The firms overall marginal after-tax cost of capital was about 12 percent. How- ever, because of the higher risks associated with an Indian venture, CPC decided that a 16 percent discount rate would be applied to the project. Present value factors at 16 percent are as follows: Sales forecasts are as follows: Year (Domestic) 5,000 6,000 7,000 8,000 (Export) 10,000 12,000 14,000 16,000 1 2 3 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Period 1 . . . . . . . . . . . . . 2 . . . . . . . . . . . . . 3 . . . . . . . . . . . . . 4 . . . . . . . . . . . . . Factor 0.862 0.743 0.641 0.552 Sales (units) The initial selling price of an electric motor was to be Rs 4,500 for Indian domestic sales and export sales in the Asian region, and the selling price in both cases was

to increase at an annual rate of 10 percent. The exchange rate between the Indian rupee and the U.S. dollar was expected to vary as follows: The cash expenditure for operating expenses, excluding interest payments, would be Rs 44 million in Year 1 and was expected to increase at a rate of 8 percent per year. The Indian subsidiary is expected to pay a royalty of Rs 20 million to the parent company at the end of each of the four years. In addition, in those years in which the subsidiary generates a profit, it will pay a dividend to CPC equal to 100 percent of net earnings. Through negotiation with the Indian government, the subsidiary will be exempt from Indian corporate income taxes and withholding taxes on payments made to the parent company. Royalties and dividends received from the Indian subsidiary are fully taxable in the United States at the U.S. corpo- rate tax rate of 35 percent. CPC expects to be able to sell the Indian subsidiary at the end of the fourth year for its salvage value. CPC also expects to be able to repatriate to the parent the cash balance at the end of Year 4. The cash balance will be equal to the difference between the aggregate amount of cash from operations generated by the subsid- iary and the aggregate amount of dividends paid to CPC, after paying back the local bank loan. The repatriated cash balance will be taxed in the United States at 35 percent only if there is a gain after deducting the cost of the original investment. Required Using the information provided, you are required to 1. Calculate net present value from both a project and a parent company perspective. 2. Recommend to CPC corporate management whether or not to accept the proposal.