hello i am doing this exercise on corporate finance capital budgeting which i have attached. in page 4 at the bottom of the page the professor makes this calculation to find foreign currency gains. can someone enlighten me how to calculate this?

Finisterra S.A. Finisterra, S.A., located in Mexico, manufactures frozen Mexican food for the domestic market and for the U.S market. In order to be closer to its U.S. customers, Finisterra is considering moving some of its manufacturing operations to southern California. Operations in California would begin in year 1 and have the following attributes: Assumptions Initial investment, year 0 Sales price per unit, year 1 Sales price increase, per year Initial sales volume, year 1, units Sales volume increase per year Production cost per unit, year 1 Production cost per unit increase, per year General and administrative expenses per year Depreciation expenses per year Termination value, year 3 Finisterra's cost of capital (pesos) U.S. subsidiary's cost of capital (USD) Value USD 5,000,000 USD 5 3% 1,000,000 10% USD 4 4% USD 100,000 USD 80,000 USD 8,000,000 16% 12% The project's horizon is 3 years. The peso/dollar exchange rate currently MXN/USD 8.00 and is expected to be MXN/USD 9.00 (year 1), MXN/USD 10.00 (year 2) and MXN/USD 11.00 (year 3). The operations in California will pay 100% of its accounting profit (=net income) to Finisterra as an annual dividend. Corporate income taxes are equal to 30% in the U.S. and in Mexico . A tax treaty between Mexico and the United States stipulates that dividends paid out to foreign companies are exempted from withholding taxes because these items are subject to corporate taxation in the destination country. 1. Determine the (adjusted) Net Present Value from the subsidiary's viewpoint and from Finisterra's viewpoint and advise Finisterra's management board on the investment decision to set up a production facility in California. Answer: First, you calculate the EBIT for each year for the U.S. subsidiary (all cash flows are in USD): Year 0 Sales price per unit Sales volume Revenues Production costs per unit Total production cost General expenses Depreciation Initial Investment Total costs EBIT 5,000,000 5,000,000 -5,000,000 Year 1 5 1,000,000 5,000,000 4 4,000,000 100,000 80,000 Year 2 5.15 1,100,000 5,665,000 4.16 4,576,000 100,000 80,000 Year 3 5.3045 1,210,000 6,418,445 4.3264 5,234,944 100,000 80,000 4,180,000 820,000 4,756,000 909,000 5,414,944 1,003,501 Then, you calculate the NPV for the subsidiary based on the free cash flows: Subsidiary's viewpoint EBIT Taxes (30%) Depreciation Termination value Free Cash Flow = 5,000,000 + Year 0 -5,000,000 Year 1 820,000 -246,000 80,000 Year 2 909,000 -272,700 80,000 -5,000,000 654,000 716,300 Year 3 1,003,501 -301,050 80,000 8,000,000 8,782,451 654,000 716,300 8,782,451 + + = USD\t2,406,133 1 + 0.12 1 + 0.12 1 + 0.12 There is no information on the financing of this project, so you can ignore the financial side effects. Also, because 100% of the profit is paid out as dividend, this suggests that the parent company owns 100% of the shares of the subsidiary. Real options or growth opportunities are not mentioned, so you don't have to consider this. Thus, from the subsidiary's viewpoint this investment seems interesting. The estimated net present value is positive, which means that the return on the investment is higher than 12%, the required return on a similar investment. However, this number should be interpreted with caution, as it relies on many assumptions. Therefore, a sensitivity analysis should be done, verifying how the NPV would change if (for example) sales increase at a slower pace, termination value is lower than expected, costs increase faster than expected, cost of capital is higher,... Calculate the NPV for Finisterra (cash flows should be converted to Mexican peso): Parent's viewpoint - 100% equity financing Year 0 EBIT -5,000,000 Taxes (30%) Net income Dividends (USD) Exchange rate MXN/USD 8 Gross dividends (MXN) Taxes (30%) Net dividends (MXN) Termination value (MXN) Free Cash Flow (MXN) -40,000,000 Discount factor (16%) 1 NPV 26,270,645 = 40,000,000 + Year 1 820,000 246,000 574,000 574,000 9 5,166,000 -1,549,800 3,616,200 Year 2 909,000 272,700 636,300 636,300 10 6,363,000 -1,908,900 4,454,100 3,616,200 0.8621 4,454,100 0.7432 3,616,200 4,454,100 93,408,870 + + = 1 + 0.16 1 + 0.16 1 + 0.16 Year 3 1,003,501 301,050 702,451 702,451 11 7,726,958 -2,318,087 5,408,870 88,000,000 93,408,870 0.6407 26,270,645 Also from the parent's viewpoint, this seems to be an interesting investment opportunity. However, the annually received dividend and the termination value benefit from the expected appreciation of the U.S. dollar. If the appreciation of the dollar doesn't materialize (if the assumption of relative purchasing power parity doesn't hold), the NPV for the parent company will lower and if the USD depreciates relative to the Mexican peso, the effect will be magnified. Also, the investment horizon is set to three years, which is very short for this kind of project. A correct assessment of a potential termination (or continuation) value may also change the result significantly. 2. How would your answer change if Finisterra decides to finance the investment with USD 2,000,000 in equity and an internal loan of USD 3,000,000 (an internal loan is a loan from the parent company to the subsidiary). The loan has a maturity of 5 years and is fully amortizing at 7% per year. The annual interest and principal payments are shown in the table below: Outstanding debt 3,000,000 2,478,328 1,920,139 1,322,876 683,806 0 Year 0 1 2 3 4 5 Interest Principal Total debt service 210,000 173,483 134,410 92,601 47,866 521,672 558,189 597,262 639,071 683,806 731,672 731,672 731,672 731,672 731,672 Answer: The net present value calculations for the subsidiary remain the same. But now, there is a financial side-effect: the interest tax shield. The subsidiary pays interest on the loan. The interest payment can be booked as a cost, which reduces gross profits and thus reduces taxes. Lower taxes are an advantage, so this should be added to the NPV calculated in part 1. The interest tax shield is equal to: 0.3 210,000 0.3 173,483 0.3 134,410 0.3 92,601 0.3 47,866 + + + + = !"\t168,684 1 + 0.07 1 + 0.07 1 + 0.07 1 + 0.07 1 + 0.07 The adjusted NPV from the subsidiary's viewpoint is: USD\t2,406,133\t+\tUSD\t168,684\t=\tUSD\t2,574,817 Thus, the debt financing has increased the (adjusted) NPV of the investment project (from the viewpoint of the subsidiary). However, we don't take into account the fact that an increasing amount of debt comes with (indirect) costs. The risk of financial distress increases. The subsidiary is financed with 40% equity (2 million) and 60% debt (3 million). So the debt-to-equity ratio is 1.5., which is relatively high. The company should evaluate carefully whether the advantage generated by the interest tax shield outweighs the increased risk of financial distress. The NPV calculations for the parent change significantly. As the received dividends are based on the subsidiary's accounting profits, we have to recalculate profits first. As the equity share of the parent has dropped to 40%, only 40% of profits will be paid out as dividends. Finisterra does receive an annual payment under the form of interest and principal repayment for the provided loan. Usually interest payments are subjected to a withholding tax, but as we don't have information on withholding taxes in this exercise, we can ignore this. However, the received dividends and interest payments are taxed as corporate income in Mexico. The repayment of the principal is not taxed. Parent's viewpoint - 60% debt financing Year 0 EBIT -5,000,000 Interest EBT -5,000,000 Taxes (30%) Net income -5,000,000 Dividends (USD) Interest payment (USD) Exchange rate MXN/USD 8 Dividends + Interest (MXN) Foreign exchange gains on capital Revenues (MXN) Taxes (30%) Net Revenues (MXN) Principal repayment (MXN) Termination value FCF (MXN) -40,000,000 Discount factor (16%) 1 NPV 41,382,264 Year 1 820,000 210,000 610,000 183,000 427,000 170,800 210,000 9 3,427,200 521,672 3,948,872 1,184,662 2,764,210 4,173,377 Year 2 909,000 173,483 735,517 220,655 514,862 205,945 173,483 10 3,794,277 1,116,378 4,910,656 1,473,197 3,437,459 4,465,513 6,937,587 0.862069 7,902,972 0.743163 Year 3 1,003,501 134,410 869,091 260,727 608,364 243,346 249,811 11 5,424,722 4,969,093 10,393,815 3,118,145 7,275,671 13,250,915 88,000,000 108,526,586 0.64065767 Because this is a U.S. dollar-denominated loan, it creates foreign currency exposure for the parent firm that uses Mexican peso as its functional currency. The loan can be considered as a foreign currency denominated investment, with a fixed annual repayment. More specifically, the fx-loan creates a positive exposure for Finisterra to the USD. Because the US dollar is expected to appreciate relative to the peso, the investment is expected to generate foreign currency gains. The foreign currency gains resulting from the interest received are already taken into account, because interest is part of the taxable income. For the debt service, we have to separate the part that is \"pure repayment of capital\" from the part that is \"foreign currency gain\". This is because the foreign currency gains are taxed, while repayment of capital is exempt from taxation. The split between foreign exchange gains and pure capital repayment is equal to: Year Principal (USD) Exchange rate MXN/USD Foreign ccy gains (MXN) Pure principal (MXN) 0 8 1 521,672 9 521,672 4,173,377 2 558,189 10 1,116,378 4,465,513 3 597,262 11 1,791,787 4,778,099 4 639,071 11 1,917,212 5,112,566 5 683,806 11 2,051,417 5,470,445 Because the expected spot rates for years 4 and 5 were not given and we have no information about inflation rates, we assume that the exchange rate stays stable as of year 3. The foreign currency gain is calculated as: # $%&' = (!)* !)+ , .&'/&0%1234 The pure principal is calculated as: 5.6\t0.&'/&0%1 = !+ .&'/&0%1234 The NPV from the parent's point of view is now equal to: 40,000,000 + 6,937,587 7,902,972 108,526,586 + + = 1 + 0.16 1 + 0.16 1 + 0.16 41,382,264 Philips Lightning Philips Lightning, based in the Netherlands and the global market leader in the manufacturing of lightning solutions, is considering an investment in a light bulb plant in China. The project requires and initial investment of CNY 13,500,000, which represents the costs for the construction of the plant, i.e. CNY 12,000,000 and general administrative expenses for an amount of 1,500,000. The plant is depreciated on a straight-line basis over 5 years to a zero salvage value. In the first year, additional working capital is required for a total amount of CNY 450,000, to be recovered at the end of the third year. After three years, Philips plans to sell the production facility to a local firm. The estimated sale price is equal to CNY 7,000,000. Total revenues are expected to be CNY 15,000,000 in the first year. Production costs are 30% of sales revenue and fixed operating costs in the first year are equal to CNY 1,800,000. Philips expects that revenues and fixed costs will increase at the Chinese rate of inflation, which is 5% per year. Corporate income tax in China is equal to 25% and the cost of capital used to evaluate Chinese light bulb factories is equal to 32%. Corporate income taxes in the Netherlands are equal to 28%. Philips decides to finance the investment project 100% with equity, and stipulates that the full net income (=accounting profit) of the Chinese subsidiary will be paid to Philips as dividend. China levies a 15% withholding tax on dividends paid to foreigners. The cost of capital of Philips Lightning is 18%. Currently, the Chinese yuan trades at EUR/CNY 0.1100. Inflation rates in China are equal to 5% per year, while inflation in the Euro-zone is 3% per year. 1. Determine whether this investment project is interesting from the viewpoint of the Chinese subsidiary. The Free Cash Flows of the Chinese subsidiary are as follows: Subsidiary's viewpoint Year 0 Sales revenues Production costs Fixed costs Depreciation Initial investment EBIT Taxes (25%) Depreciation Changes in NWC Termination value FCF Discount factor (32%) NPV Year 1 15,000,000 -4,500,000 -1,800,000 -2,400,000 Year 2 15,750,000 -4,725,000 -1,890,000 -2,400,000 Year 3 16,537,500 -4,961,250 -1,984,500 -2,400,000 6,300,000 -1,575,000 2,400,000 -450,000 6,735,000 -1,683,750 2,400,000 -13,500,000 6,675,000 7,451,250 7,191,750 -1,797,938 2,400,000 450,000 7,000,000 15,243,813 1 2,461,084 0.75758 0.57392 0.43479 -13,500,000 -13,500,000 At a cost of capital of 32%, the NPV of this investment project from the subsidiary's viewpoint is equal to CNY 2,461,084. There are no financial side effects or real options, so the NPV = adjusted NPV. As the NPV of the project is positive, this is a good investment from the viewpoint of the subsidiary. If all assumptions hold, the return on the investment will be higher than the cost of capital, i.e. the required return of 32%. However, a sensitivity analysis is needed to check the impact of some assumptions (for example, how sensitive is the NPV to changes in sales numbers, costs, taxes, ...). 2. Determine whether this investment project is interesting from the viewpoint of Philips Lightning, the Dutch parent company. Parent's viewpoint EBIT (CNY) Taxes (25%) Net income Gross dividend Withholding tax (15%) Net Dividend Revenues (CNY) Exchange rate Gross revenues (EUR) Taxes (28%) Net revenues (EUR) Termination value (EUR) FCF (EUR) Discount factor (18%) NPV -13,500,000 -13,500,000 -13,500,000 0.11 -1,485,000 -1,485,000 -1,485,000 1 -334,581 6,300,000 -1,575,000 4,725,000 4,725,000 -708,750 4,016,250 4,016,250 0.1079 433,373 -121,344 312,028 6,735,000 -1,683,750 5,051,250 5,051,250 -757,688 4,293,563 4,293,563 0.1058 454,471 -127,252 327,219 312,028 0.84746 327,219 0.71818 7,191,750 -1,797,938 5,393,813 5,393,813 -809,072 4,584,741 4,584,741 0.1038 476,049 -133,294 342,755 726,833 1,069,588 0.60863 From the parent's point of view, the investment opportunity is less interesting. The net present value is negative, which means that the expected realized return for this project is lower than the required return of 18%. Because of the absence of a tax treaty between China and the Netherlands, the profit realized by the Chinese subsidiary is taxed three times (corporate income tax in China, withholding tax on the dividend and corporate income tax in the Netherlands). Also, the Chinese yuan is expected to depreciate (based on relative PPP), which results in a lower euro value for the dividend revenues. However, one could question whether the assumption of relative PPP is applicable in this case. The People's Bank of China controls the yuan exchange rate and does not allow the currency to fluctuate much. Therefore, a sensitivity analysis is needed, in which we consider different alternatives for the future EUR/CNY exchange rates. 3. How would your answers to questions (1) and (2) change if Philips decides to continue operating the Chinese production facility after year three, instead of selling it? In this case, Philips believes that after year 3, the FCF will grow indefinitely at the Chinese rate of inflation (5% per year). What can you conclude based on your calculations? Subsidiary's viewpoint: Subsidiary's viewpoint - alternative termination value Year 0 Year 1 Sales revenues 15,000,000 Production costs -4,500,000 Fixed costs -1,800,000 Depreciation -2,400,000 Initial investment -13,500,000 EBIT -13,500,000 6,300,000 Taxes (25%) -1,575,000 Depreciation 2,400,000 Changes in NWC -450,000 FCF -13,500,000 6,675,000 Terminal value Discount factor (32%) NPV 1 13,356,571 Year 2 15,750,000 -4,725,000 -1,890,000 -2,400,000 Year 3 16,537,500 -4,961,250 -1,984,500 -2,400,000 6,735,000 -1,683,750 2,400,000 7,191,750 -1,797,938 2,400,000 450,000 8,243,813 32,059,271 7,451,250 0.75758 0.57392 6,300,000 -1,575,000 4,725,000 4,725,000 -708,750 4,016,250 4,016,250 0.1079 433,373 -121,344 312,028 6,735,000 -1,683,750 5,051,250 5,051,250 -757,688 4,293,563 4,293,563 0.1058 454,471 -127,252 327,219 312,028 0.84746 327,219 0.71818 0.43479 Parent's viewpoint: Parent's viewpoint - alternative termination value EBIT (CNY) -13,500,000 Taxes (25%) Net income -13,500,000 Gross dividend Withholding tax (15%) Net Dividend FCF (CNY) -13,500,000 Exchange rate 0.11 Gross revenues (EUR) -1,485,000 Taxes (28%) Net revenues (EUR) -1,485,000 Terminal value FCF (EUR) -1,485,000 Discount factor (18%) 1 NPV 1,563,236 7,191,750 -1,797,938 5,393,813 5,393,813 -809,072 4,584,741 4,584,741 0.1038 476,049 -133,294 342,755 3,845,007 4,187,762 0.60863 Continuing the operation is definitely more profitable than selling it. This indicates that the estimated sale price of CNY 7,000,000 in the first scenario is too low. Thus, if Philips decides to sell the plant at the end of the third year, the company should negotiate a better price. However, one can argue whether an infinite growth rate of 5% is realistic. Few firms live forever and cash flows will fluctuate year by year. So probably, the terminal value in this second scenario is somewhat overstated