Hello,

This question is solved the only problem I am having is that the foreign exchange ratefor question #2 is obsolete. Will need an updated one to calculate and find the right answer. This should be from Feb 2012 to Feb 2016. Thanks

Global Investment case The Gibson Company is a United States (US) firm that is considering a joint venture with Brasilia, DF, a Brazilian firm that grows and processes coffee beans. Gibson has a patent for a new coffee processing method. This intellectual property is motivating Gibson to expand beyond importing coffee to engaging in a joint venture to process the coffee. Gibson will invest $8 million in the proposed joint venture project, which will help to finance Brasilia 's production using the newly patented process. The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at http://www.oanda.com. For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company. The expected total profits resulting from the joint venture per year are as follows: Year 1 2 3 4 Total Profits from Joint Venture (in 40 BRL) million 60 million 70 million 90 million 5 120 million Gibson's average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibson's US income tax rate is 10 percent. Gibson's capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates. Gibson is concerned about country risk in the following two forms: (1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs, Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this joint venture. (2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson (20 percent probability)? If this occurs, Gibson will not receive additional tax credits, and the company will still be subject to US tax on the profits from this joint venture. Assume that the two types of country risk are mutually exclusive. If it does anything, the Brazilian government will only implement one of these changes in its tax p (i.e., the increase in the basic income tax on the profits of the joint venture or the additional income tax on profits distributed to foreign companies). The Brazilian go may also choose to leave things as they are. Assignment 1. Determine Gibson's cost of capital and required rate of return for the joint venture in Brazil. 2. Determine the discrete probability distribution of Gibson's Net Present Value for this joint venture and calculate the Expected Net Present Value. 3. Would you recommend that Gibson participate in the joint venture? Explain. 4. What do you think would be the key underlying factor that would have the most influence on the profits earned in Brazil as a result of the joint venture? 5. Under what circumstances might Gibson shift to more equity financing when considering joint ventures like this? What is the minimum required return that would still make this investment worthwhile? 6. When Gibson was assessing this proposed joint venture, some of the managers in the company recommended that it borrow the Brazilian currency rather than using US dollars to obtain some of the necessary capital for the initial investment. They suggested that such a strategy could reduce Gibson's exchange rate risk. Do you agree? Explain. 7. Discuss the benefits of the joint venture from the perspective of Brasilia. What is the maximum amount of money Brasilia should invest? ans. a joint e newly rent be sent to e present imposing id in from n its tax policies razilian government that r ange Week 8 Global Investment Case 1 Determine Gibson's cost of capital and required rate of return for the joint venture in Brazil. Capital Pretax Cost Tax Rate Equity Debt 6.00% 10.00% Weighted Average Cost of Capital (WACC) Required Rate of Return Aftertax Cost 9.00% 5.40% Capital Structure 30.00% 70.00% Weighted Aftertax Cost 2.70% 3.78% 6.48% 2% Risk Premium 5% Risk Premium Selected: 4% Risk Premium 2.00% 8.48% 5.00% 11.48% 4.00% 10.48% 2 Determine the discrete probability distribution of Gibson's Net Present Value for this joint venture and calculate the expected value. Step A: Determine net present value for each scenario Tax 10% Probability 60% Year 0 1 2 3 JV Profit BRL 40,000,000 60,000,000 70,000,000 Gibson 40% 16,000,000 24,000,000 28,000,000 Brazil Tax 1,600,000 2,400,000 2,800,000 Aftertax BRL 14,400,000 21,600,000 25,200,000 $US $7,845,120 $11,767,680 $13,728,960 US Tax 7% $549,158 $823,738 $961,027 Aftertax $US -$8,000,000 $7,295,962 $10,943,942 $12,767,933 NPV $6,603,875 $8,966,160 $9,468,247 IRR This is a 5-year project, so rates of exchange are used for 5 years. Exchange Rates March 2008-March 2013 $US to 1 Brazilian Real Period Average 4 90,000,000 36,000,000 3,600,000 32,400,000 $17,651,520 $1,235,606 $16,415,914 $11,018,701 Assume all cash flows are yearend Period High 0.6442 Period Low 0.4062 5 Total 120,000,000 380,000,000 Source: http://www.oanda.com 48,000,000 152,000,000 4,800,000 15,200,000 Tax 10% 43,200,000 136,800,000 Average $23,535,360 $74,528,640 1 Brazilian Real $0.54 $1,647,475 $5,217,005 US tax 7% $21,887,885 $69,311,635 $13,297,974 $49,354,957 $49,354,957 NPV 118.70% IRR Tax 10% & 10% Probability Gibson 40% 16,000,000 24,000,000 Brazil Tax 1,600,000 2,400,000 Aftertax BRL 14,400,000 21,600,000 Tax on Foreign Corporations 1,440,000 2,160,000 Aftertax BRL 12,960,000 19,440,000 $US $7,060,608 $10,590,912 Aftertax $US -$8,000,000 $6,566,365 $9,849,548 NPV $5,943,488 $8,069,544 IRR 20% 28,000,000 2,800,000 25,200,000 2,520,000 22,680,000 $12,356,064 $11,491,140 $8,521,423 36,000,000 3,600,000 32,400,000 3,240,000 29,160,000 $15,886,368 $14,774,322 $9,916,831 48,000,000 4,800,000 43,200,000 4,320,000 38,880,000 $21,181,824 $19,699,096 $11,968,176 152,000,000 15,200,000 Tax 10% 136,800,000 13,680,000 Tax 10% 123,120,000 $67,075,776 1 Brazilian Real $62,380,472 US tax 7% $44,419,461 $44,419,461 108.07% Tax 30% JV Profit BRL Gibson 40% Aftertax BRL $US* -$8,000,000 NPV IRR * No US tax 20% 70,000,000 28,000,000 19,600,000 $10,678,080 $7,918,486 90,000,000 36,000,000 25,200,000 $13,728,960 $9,215,162 120,000,000 48,000,000 33,600,000 $18,305,280 $11,121,364 380,000,000 152,000,000 106,400,000 Tax 30% $57,966,720 1 Brazilian Real $41,276,547 $41,276,547 101.17% 40,000,000 16,000,000 11,200,000 $6,101,760 $5,522,954 Probability 60,000,000 24,000,000 16,800,000 $9,152,640 $7,498,580 Step B: Determine likelihood for each scenario Scenarios Probabilities Explanation Tax 10% 60% By elimination: 100% - 20% - 20% Tax 20% 20% Given Tax 30% 20% Given Total Probability 100% Step C: Determine expected net present value Revised X Probabilities Tax 10% 60% Witholding tax 10% 20% Tax 30% 20% Total Expected NPV 100% 0.5448 NPV $49,354,957 $44,419,461 $41,276,547 = $0.54 NPV IRR $0.54 NPV IRR Note: probabilities must sum to 100% for events that are mutually exclusive and collectively exhaustive. Expected NPV Expected NPV If BRL at $29,612,974 $8,883,892 $8,255,309 $46,752,176 $0.41 $22,079,277 $6,623,783 $6,155,115 $34,858,175 3 Would you recommend that Gibson participate in the joint venture? Explain. Yes, I would recommend that Gibson does participate: a) The total expected net present value is large and positive. b) All 3 scenarios have positive net present values, no scenario has a loss outcome. c) Even if BRL falls to 5-year low, the expected NPV is still $34,858,175 4 What is the key underlying factor most influencing joint venture profits? Based on the numbers, the key factor is whether or not Brazilian tax goes to 30%. Qualitatively, key factors are whether: a) The patented process works, and forecast cash flows are achieved. b) Coffee prices do not fall to any significant extent. c) Brazil keeps its word about FX rate of conversion to $US. 5 year low rate (if the Real depreciates greatly, the Brazilian government may have difficulty in honoring this commitment). 5a When might Gibson shift to more equity financing? Debt is regarded as less risky than equity by investors, and therefore has a lower cost than equity. So usually firms use debt as much as possible. In addition, interest on debt is tax deductible by the borrower, whereas equity financing provides no tax deductions. Those are two reasons to use debt. But lenders demand an equity cushion, and the greater their perception of the firm's risk, the greater the equity cushion that they demand. For this reason, Gibson might shift to more equity financing if the risk of the joint venture were to increase to a significant extent. 5b What is the minimum required return that would still make this investment worthwhile. The minimum required rate of return that would still make this investment worthwhwhile is 10.48% which is the required rate of return. The maximum required rate of return that would still make this investment worthwhwhile is anything greater than the required rate of return, which is 10.48% Therefore the project is acceptable at any required rate of return between 10.48% and infinity. 6 Would borrowing Brazilian currency reduce Gibson's exchange rate risk? If absolute reliance can be placed upon the Brazilian government's guarantee of the exchange rate, then borrowing Brazilian currency would not affect exchange rate risk. However, if less than absolute reliance can be placed, then borrowing Brazilian currency would reduce exchange rate risk, provided that Brazilian currency did not appreciate significantly relative to the $US, resulting in having to repay the debt at a premium. 7 What are the benefits of the joint venture to Brasilia? What is the maximum amount that Brasilia should invest? Brasilia benefits by receiving 60% of the joint venture's profits, and by acquiring the new equipment and processing technology. The maximum amount Brasilia should invest depends on its required rate of return. Assume that its required rate of retu 12.00% Then the maximum investment should be as follows: Year 1 JV Profit BRL 40,000,000 Brasilia 60% 24,000,000 Assume 10% tax 2,400,000 Aftertax Profit 21,600,000 Present Value 19,285,714 2 60,000,000 36,000,000 3,600,000 32,400,000 25,829,082 The maximum investment should be 3 70,000,000 42,000,000 4,200,000 37,800,000 26,905,293 4 90,000,000 54,000,000 5,400,000 48,600,000 30,886,179 139,675,528 BRL 5 120,000,000 72,000,000 7,200,000 64,800,000 36,769,260 Total 380,000,000 228,000,000 22,800,000 205,200,000 139,675,528 BRL which is the present value of the Brasilia cash inflows