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Need answers to Question 1 and 3 of the attachment It is the end of the year, and Ace, Inc., a US company, has been
Need answers to Question 1 and 3 of the attachment
It is the end of the year, and Ace, Inc., a US company, has been approached by Lakson Group, a company from Pakistan, to explore the possibility of a joint venture in Pakistan to produce widgets. This year, Ace exported 100,000 widgets to Pakistani importer SS Import-Export Co. at 5,000 Pakistan rupees (PKR) each. The spot exchange rate is 100 PKR per $1. Each widget costs Ace $30 to produce and ship to Pakistan. Ace estimates that from now on widget sales in Pakistan will increase at a 5% annual rate. Production of widgets in Pakistan requires the construction of a plant which, at the prevailing spot exchange rate, has an immediate cost of $6,000,000 to be equally shared by the two firms. The plant could be depreciated on a straight-line basis over 8 years. In addition, it is estimated that at the prevailing spot exchange rate each partner must contribute $500,000 of net working capital right away to launch the joint venture. The total cost of production in Pakistan is currently estimated to be 2300 PKR per widget and is expected to remain unchanged over the following five years. Part of this cost is for components produced by Ace in the US, at a cost of $5, and then supplied to the joint venture plant in Pakistan at $7 per widget. SS Import-Export has agreed to buy the widgets produced in Pakistan over the next five years at the same price it currently pays to import them from the US. The applicable tax rate in Pakistan, and in the US, is 35%. Five years after the joint venture is established, Ace will pull out and in return it will recover in full its investment in net working capital and it will also sell its share of the plant to Lakson for an amount equal to 110% of its share of the plant's book value at that time. To promote investment by US firms in Pakistan, the US government has agreed that the sale of Ace's share of the plant to Lakson five years from now has no tax implications. In addition, the Pakistani government has agreed that at the end of each of the next five years Ace may remit its share of the joint venture's net cash flows to the US at the prevailing exchange rate. You are in charge of evaluating the joint venture for Ace. You believe that projects similar to that in the joint venture would require a 12% rate of return if undertaken in the US. Further, your assistant has provided the following input about the projected inflation rates over the next five years: 1. Provide calculations using the \"foreign country approach\" and the \"home country approach\". Year 1 2 3 4 5 US 1% 1% 2% 2% 2% Pakistan 3% 4% 6% 6% 6% 2. Safran is a French conglomerate actively planning to expand its operations in Pakistan. If Ace enters in the joint venture now, Safran wants to enter into an agreement to buy Ace's portion of the joint venture two years from now for 4,500,000. At the time of the purchase, the indirect exchange rate between the euro and the Pakistani rupee is estimated to be PKR 113 per euro. Should Ace enter in such an agreement with Safran now? 3. Assume that Ace decides to enter in the joint venture. However, unlike part 1 above, Ace does not have the $3,500,000 required for the initial investment in the project. Hence, Ace decides to ask its US bank for a dollar-denominated loan now against its share of the joint venture's future net cash flows. Ace's annual net cash flows from the joint venture will be directed to its US bank until the loan is fully repaid; afterwards, Ace will collect the remaining cash flows. Further, as long as Ace can enter in to a forward contract with a third party to convert its PKR denominated net cash flows from the joint venture to dollars at a favorable rate, Ace's US bank is willing to charge a 10% annual interest rate on the loan. The Bank of Khyber, a Pakistani bank, is willing to act as the counter-party of the forward contract and offers to remit all future net cash flows to Ace or its US bank at the fixed exchange rate of 110 PKR per $1. If it proceeds with the joint venture, how long would it take Ace to repay its loan? Would you recommend that Ace takes the loan and enters in the forward contract so it can proceed with the joint venture? Would your recommendation in the previous bullet change if the Bank of Khyber asks for a $500,000 fee payable immediately to enter the forward contract? (Remember, Ace does not have any cash available now so it will have to also borrow the money to pay this fee.) What is the maximum PKR/$ exchange rate Ace can accept in the forward contractStep by Step Solution
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