Case Study

Nelson Plc $($NLP$)$ is a Canadian company with a solid national reputation for innovative

business systems. It has four divisions: manufacturing, Software Development, Business

Systems Development and Sales$/$Distribution$.$ All the divisions are based in Canada, with a

Head Office based in Montreal. Two years ago, NLP decided to start selling its services

internationally using a team of salespeople to visit different countries.

The initiative has not been particularly successful, and the company is considering the

proposal that it should radically restructure its operations along the following lines:

$$ Relocate some of the manufacturing divisions to low$-$cost countries such as China

$$ Relocate parts of the software development division in India

$$ Considerably reduce the size of the sales$/$distribution division in Canada and replace

it with regional offices in as many different countries as possible

NLP is considering a name change to the International NL Systems. The plan would be to

restructure by combining wholly or partly owned overseas subsidiaries, branches, franchises

and joint ventures. The process will require a considerable amount of new finance, but the

intention would be to spread the change over several years.

The NLP$$s board of directors members have not agreed on this proposal, although they mostly

appreciate the need to restructure. However, some committee members have significant

doubts about certain aspects of the proposal. These include:

$$ The costs involved in setting up overseas subsidiaries

$$ There are additional risks involved in operating overseas, primarily in less

developed countries.

This board faction generally emphasises franchising its overseas operations because it will

require less new capital.

The company has recently been approached by a consortium of businesses from Hong Kong,

where NLP has enjoyed the most success, with a proposition for a franchise arrangement. The

terms of the agreement are that NLP would:

$$ contribute HK$$66$ million for the purchase of fixed assets

$$ provide technical support in the setting up and running of the franchise $($NLP estimates

that this will cost the company C$$600,000$ per year for the life of the arrangement$)$

$$ sell the franchise outright to the consortium after three years for a one$-$off payment

of HK$$6$ million

$$ receive half of the net cash flows for the three years of the agreement

$$ agree to pass over any existing arrangements with customers in Hong Kong to the

franchise and not seek any future customers on its account.

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Net cash flows from the franchise are estimated at HK$$40$ million in the first year of operation,

increasing at $20\%$ yearly for each of the next two years. NLP forecasts that there will be a net

loss of contribution of C$$0\mathrm{.}7$ million per annum from its existing Hong Kong customers for the

first year of the franchise and that this could be expected to double year on year for the next

two years the franchise.

One of NLP$$s directors is concerned that the franchise may be too sensitive to changes in

some of the forecast variables of the proposal. In particular, he is concerned that the forecast

of HK$$66$ million may be too low to purchase the fixed assets required. He also feels that the

NLP$$s cost of capital may increase due to the company taking on the franchise.

The spot exchange rate is HK$$6$ to the C$$.$ However, this is expected to change over the

project's life, as inflation in Canada is currently only $1\%,$ whilst it is $3\%$ in Hong Kong.

NLP$$s weighted average cost of capital is estimated at $11\%,$ and the company has a debt$-$to$-$

equity ratio of one to one based on market values. The company wishes to maintain its

current debt$-$to$-$equity ratio and intends to fund the franchise arrangement using a

combination of debt and equity. The company thinks it will raise additional debt at the same

interest rate as its current debt. However, it fears the cost of equity may rise to $16\%$ from $14\%$

due to a lack of franchising experience.

Assume that all the cash flows above have already been adjusted for the expected effects of

inflation.

Ignore taxation.

You are in charge of the finance function in Canada and have been asked to produce a report

which covers:

$$ the Hong Kong Franchise

$$ the additional burdens that will face your department if the company decides on

the option to set up subsidiaries abroad

$$ an evaluation of the financing of the overseas acquisitions

$$ the benefits that can accrue from the multinational status

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Required:

Produce a report which covers the following:

a$)$ Evaluate the franchise arrangement using the company$$s revised weighted average

cost of capital. Briefly discuss any reservations you may have regarding the figures

you have produced.

$($Note: If you cannot calculate NLP$$s revised weighted average cost of capital,

you may use its current rate $$ although fewer marks will be awarded. You are also

expected to use at least NPV for evaluating the project$).$

Your report should address the concerns

what will be the revised weighted average cost of capital