Delta (K) Ltd is a specialist manufacturer of window frames. It is based mainly in Kenya from where it distributes its products. The directors are considering whether to open up a subsidiary in Nigeria. A factory has been located in Lagos that could be rented on a 5 year lease at an annual charge of N3.8 million payable each year. The manufacturing equipment would cost N750 million of which N600 million would have to be paid at the start of the project with the balance payable 12 months later.

At the start of each year, the Nigerian factory would require working capital equal to 40% of that years sales revenues. It is expected that the factory will be able to produce and sell 80,000 window units per year although in the first year the expected output is 50,000 units. Each window is likely to be sold for N7500 which is a price that represents 150% mark up on cash production costs.

The Nigerian factory would be set up as a wholly owned subsidiary of Delta (K) Ltd. In Nigeria, 25% straight line depreciation is an allowable expense against the company tax. Corporation tax is payable at 40% at each year end without delay and any losses can be brought forward for set off against the following years profits. No Kenyan tax would be payable on the after tax Nigerian profits.

All amounts in Naira are given in current terms. Annual inflation in Nigeria is expected to run at 6% per year in the foreseeable future. All Nigerian Factory cash flows involved are expected to increase in line with this inflation rate with the exception of the factory rental and the cost of manufacturing equipment both of which will remain unchanged.

The Nigerian factory would be producing windows to a special design patented by Delta (K) Ltd. To protect its patent rights, Delta will charge its German subsidiary a fixed royalty of N20 per window. This cost would be allowable against the subsidiarys German tax liability. The current N/KES spot rate is 1.5. Inflation in Kenya is expected to be 4% per year over the period. There are no cash flow remittance restrictions between Nigeria and Kenya .

Delta (K) Ltd is an all equity financed company that is quoted on the Nairobi Securities Exchange. Its shares have a beta value of 1.25. The current annual return on Kenya government treasury bills is 10% and the expected return on the market is 18%. In Kenya, corporation tax is payable at 35% one year in arrears.

Delta operates on a 5 year planning horizon. At the end of five years assume that working capital would be fully recovered and the production equipment would have a scrap value at that time of N70 million before tax. Proceeds on asset sales are taxed at 40%. Assume all cash flows arise at the end of the year to which they relate unless otherwise stated.

Required

Evaluate the proposed investment in Naigeria and recommend what financial decision should be made by Delta (K) Ltd.