Downtown Street, a British Company, is considering establishing an operation in the United States to assemble and distributes top hats. The initial investment is estimated to be $20,000,000 (British pounds - GBP) which is equivalent to US$23,000,000 at the current exchange rate. Given the current corporate income tax rate in the United States, Downtown Street estimates that total after-tax annual cash flow in each of the three years of the investments life would be US$10,000,000, US$12,000,000, and US$15,000,000, respectively. However, the U.S. national legislature is considering a reduction in the corporate income tax rate that would go into effect in the second year of the investment's life, and would result in the following total annual cash flows: US$10,000,000 in year 1, US$14,000,000 in year two, and US$18,000,000 in year three. Downtown Street estimates the probability of the tax rate reduction occurring at 50%. Downtown Street uses a discount rate of 12% evaluating potential capital investments. Present value factors are as follows: Period PV Factor 0.893 2 0.797 3 0.712 The U.S. operation will distribute 100% of its after-tax annual cash flow to Downtown Street as a dividend at the end of each year. The terminal value of the investment at the end of three years is estimated to be US$25,000,000. Neither the dividends nor the terminal value received from the U.S. investment will be subject to a British income tax. Exchange rate between GBP and USD are forecasted as follows: Year 1 GBP 0.74 = USD 1.00 Year 2 GBP 0.70 = USD 1.00 Year 3 GBP 0.60 = USD 1.00 Determine the expected net present value of the potential US investment from a parent company perspective.Solution Calculation of NPV without tax rate change: Period GBP PV Factor Present Value Year 1 7,400,000 0.893 6,608,200 Year 2 8,400,000 0.797 6,694,800 Year 3 24,000,000 0.712 17,088,000 30,391,000 Less: Initial investment (20,000,000) NPV 10,391,000 Calculation of NPV with possible tax rate change: TACF GBP PV Factor Present Value Year 1 7,400,000 0.893 6,608,200 Year 2 9,800,000 0.797 7,810,600 Year 3 25,800,000 0.712 18,369.600 32,788,400 Less: Initial investment (20,000,000) NPV 12788.400 Calculation of Project Expected NPV: NPV Probability Expected NPV without tax rate change 10,391,000 0.50 5,195,500 with tax rate change 12,788,400 0.50 6,394,200 Project expected NPV 11,589,700