Question
Natural Mosaic. Natural Mosaic Company (U.S.) is considering investing Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European
Natural Mosaic. Natural Mosaic Company (U.S.) is considering investing Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years, the subsidiary would be sold to Indian investors for Rs100,000,000. A pro forma income statement for the Indian operation predicts the generation of Rs7,000,000 of annual cash flow, is listed in the following table.
Sales Revenue 30,000,000
Less: Cash Operating Expenses (17,000,000)
Gross Income 13,000,000
Less: Depreciation Expenses (1,000,000)
Earnings before Interest and Taxes 12,000,000
Less Indian taxes at 50% (6,000,000)
Net Income 6,000,000
Add Back Depreciation 1,000,000
Annual Cash Flow 7,000,000
The initial investment will be made on December 31, 2011, and cash flows will occur on December 31st of each succeeding year. Annual cash dividends to Philadelphia Composite from India will equal 75% of accounting income.
The U.S. corporate tax rate is 40% and the Indian corporate tax is 50%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Natural Mosaic will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Natural Mosaic uses a weighted average cost of capital of 14% on domestic investments, but will add six percentage points for the Indian investment because of perceived greater risk. Natural Mosaic forecasts the rupee/dollar exchange rate for December 31st on the next six years are listed below.
R$/$ R$/$
2011 50 2014 62
2012 54 2015 66
2013 58 2016 70
What is the net present value and internal rate of return on this investment?
Here is my answer:
The information that is already given above includes:
Initial Investment (Rs) | 50,000,000 |
Indian Corporate Tax Rate | 50% |
Sale Price in Year 5 (Rs) | 100,000,000 |
Natural Mosaic Companys WACC | 14% |
Dividend Distribution Per Year | 75% |
U.S. Corporate Tax Rate | 40% |
Indias Risk Premium to WACC | 6% |
From the project viewpoint, the net present value (NPV) can be calculated by first determining the cash flows from 2011 to 2016. Beside the annual cash flow given in the income statement above, the initial investment and the sale price also need to be considered as cash flows:
2011 -50,000,000
2012 7,000,000
2013 7,000,000
2014 7,000,000
2015 7,000,000
2016 7,000,000 + 100,000,000 = 107,000,000
Pro Forma Income and Cash Flow
Year | Cash Flows | PV Factor at 20% | PV |
2011 | -50,000,000 | 1/(1.2)0 = 1.0000 | -50,000,000 |
2012 | 7,000,000 | 1/(1.2)1 = .8333 | 5,833,333.333 |
2013 | 7,000,000 | 1/(1.2)2 = .6944 | 4,861,111.111 |
2014 | 7,000,000 | 1/(1.2)3 = .5787 | 4,050,925.926 |
2015 | 7,000,000 | 1/(1.2)4 = .4823 | 3,375,771.605 |
2016 | 107,000,000 | 1/(1.2)5 = .4019 | 43,000,900.21 |
|
|
| 11,122,042.19 |
The NPV of the project viewpoint (investment in India) is $11,122,042
The IRR of the project viewpoint (investment in India) is 25.96%
Given the Current Exchange Rate (Rs/$):
Rs/$ in 2011 50
Rs/$ in 2012 54
Rs/$ in 2013 58
Rs/$ in 2014 62
Rs/$ in 2015 66
Rs/$ in 2016 70
From the parent companys viewpoint, the net present value (NPV) and the internal rate of return (IRR) can be computed by first calculating the dividends received in the U.S. each by multiplying the net income from the income statement times the dividend distribution per year:
6,000,000 x .75 = 4,500,000
The next step is determining the cash flows for each year (from 2011-2016):
2011 4,500,000
2012 4,500,000
2013 4,500,000
2014 4,500,000
2015 4,500,000
2016 4,500,000 + 100,000,000 = 104,500,000
Using the Current Exchange Rate, convert the cash flows to the U.S. $:
Convert the cash flow in U.S. dollars:
2011: -50,000,000Rs x 1US$/50R$ = -$1,000,000
2012: 4,500,000Rs x 1US$/54R$ = $83,333
2013: 4,500,000Rs x 1US$/58$ = $77,586
2014: 4,500,000Rs x 1US$/62$ = $72,581
2015: 4,500,000Rs x 1US$/66R$ = $68,182
2016: $104,500,000Rs x 1US$/70R$ = $1,492,857
Now, calculate NPV:
Year | Cash Flows | PV Factor at 20% | Present Value |
2011 | -1,000,000 | 1/(1.2)0 = 1.0000 | -1,000,000 |
2012 | 83,333 | 1/(1.2)1 = .8333 | 69,444.16667 |
2013 | 77,586 | 1/(1.2)2 = .6944 | 53,879.16667 |
2014 | 72,581 | 1/(1.2)3 = .5787 | 420,002.89352 |
2015 | 68,182 | 1/(1.2)4 = .4823 | 32,880.97994 |
2016 | 1,492,857 | 1/(1.2)5 = .4019 | 599,945.7465 |
|
|
| -201,847.0467 |
The NPV of the project (parent viewpoint) is -$201,847.05
The IRR of this project (parent viewpoint) is 13.94%
The NPV of the project is -$201,847.05 < 0 so reject the proposed investment because the project is expected to generate less than the companys required rate of return.
These are my questions:
1. Why is PV factor at 20%?
2. What is the project required rate of return for both project viewpoint and parent viewpoint
3. How do you find NPV and IRR on financial calculator
4. Do we accept or reject IRR of 13.94%. Why?
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