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BFF2341 International Financial Management Assignment 3 (Exam Weight: 20%) Due date: Friday 20 May by 4.00 pm Major Issue Tokyo Electric Power Company, also known as TEPCO, is a Japanese company headquartered in Tokyo. It has branches in Washington D.C. and London. It is a founding member of a strategic consortium relating to energy innovation and research around the world. After identifying the huge demand for the electricity and related pollution problems, TEPCO is currently considering to invest in a next generation nuclear power plant that could be located either in Hong Kong or in Somalia. In other words, these two projects are mutually exclusive. This is an exciting news for both the Somalian and Hong Kong governments, and both governments have approved this foreign direct investment. However, TEPCO needs to decide whether it should locate this nuclear power plant in need your expertise in Hong Kong or in Somalia. They have approached your consultancy firm and requested it to evaluate the financial viability of this project. Your senior manager has assigned this job to you. You are provided with the following information: Cost and funding estimates: TEPCO estimates that the total cost for setting up the nuclear power plant would be Japanese Yen ()1, 000 billion in today's terms. The project will be funded with 250 billion equity and a 750 billion loan received from the Japan International Cooperation Agency (JICA). This financing mix is similar to TEPCO's existing capital structure. The company's weighted average cost of capital is 10% per annum. This cost of capital should be appropriately adjusted to reflect the political risk of the host country when evaluating an international investment project. Exchange rate: The today's spot rate of Japanese Yen () against the Hong Kong dollar (HKD) and Somali Shilling (SOS) is 1 = HKD 0.0708 and 1 = SOS 5.4994. One year ago, these exchange rates were 1 = HKD 0.0648 and 1 = SOS 5.6869 respectively. TEPCO has forecasted that the exchange rate trend of against HKD and SOS for the next five years will be same as it was over the last year. Thus, the current spot exchange rates and the past exchange rates can be used to forecast future exchange rates between currencies. Expected cash flows: All the power generated by the plant will be sold to the respective governments in return for annual lump sum payments in their domestic currencies. These payment will be determined as a percentage of domestic currency equivalent of the total cost of the plant which is HKD 70.8 billion (=1,000 *0.0708) and SOS 5499.4 billion (= 1,000 x 5.4994) respectively using the current spot exchange rates. The Hong Kong government has offered a tax free net payment of 15% at the end of every year for the first five years. In addition, Hong Kong government is willing to buy the plant at the end of five years by paying 75% of the initial plant cost. TEPCO can remit the annual payments to Japan after paying a 20% withholding tax. However, there will be no tax payable if the remittance is made at the end of five years. Thus, TEPCO has decided to hold all the cash flows in Hong Kong until the end of the fifth year. It is estimated that any blocked funds in Hong Kong can be invested to generate a return of 10% per annum. The offer from Somalian government is a tax free net payment of 15% at the end of every year for the first five years. In addition, Somalian government is willing to buy the plant at the end of five years by paying 80% of the initial plant cost. The Somalian government allows TESCO to remit the annual payments as well as the final payment from the sale of plant to remit to Japan at the time of receipt without any withholding tax. Required: a) Assessment of political risk (50 marks) Use appropriate online resources to develop a clear understanding of the political environments in Hong Kong and Somalia. Show your understanding by allocating a score to each of the twelve components of political risk in Table 1, and calculate an overall political risk score for each country. Based on your political risk scores, determine which country has a relatively higher political risk? Ensure to provide a brief explanation (maximum 100 words for each risk category; at the end of the Table1) to justify the score you have assigned to each component. Use the ID codes in Table 1 to identify relevant risk components when providing your comments (e.g. Code 'A' for justifying the score given to 'Government Stability' component). Table 1: POLITICAL RISK ESTIMATION ID Code Component Maximum Points A Government Stability Socioeconomic Conditions 12 C Investment Profile 12 D Internal Conflict 12 E External Conflict 12 F Corruption 6 G Military in Politics 6 H Religious Tensions 6 I Law and Order 6 J Ethnic Tensions 6 K Democratic Accountability 6 L Bureaucracy Quality Somalia 12 B Hong Kong 4 Total 100 Source: For explanations of above terms, students should refer to the original source under the heading 'The Political Risk Rating' available at the Political Risk Services group website at: www.prsgroup.com/ICRG_Methodology.aspx Comments: A - L? b) Estimation of required rate of return (5 marks) Using given information and your answer in part a, determine a required rate of return for TEPCO's investments in Hong Kong and Somalia. c) Forecast exchange rates (7 marks) Using the information provided in the assignment, develop a five-year forecast for the exchange rates of Japanese Yen () against the HKD and SOS. d) Cost of capital (7 marks) Discuss what factors would influence the cost of capital of TEPCO in the context of its international business. e) NPV Calculation (24 marks) Determine the NPVs of the plant for TEPCO (in Yen) from setting up the plant in Hong Kong and Somalia. Use an excel worksheet for calculations showing all values in millions and accurate up to four decimal places. f) Provide your recommendation to TEPCO (i.e. would you recommend investment in Hong Kong or Somalia?) Justify your answer. (2 marks) g) Briefly discuss two main factors (other than NPV) which may have contributed to your final decision in part (e). (5 marks) Some useful websites: The world fact book at: https://www.cia.gov/library/publications/the-world-factbook/geos/ch.html The World Bank database at: http://data.worldbank.org/ Political Risk Services at: http://www.prsgroup.com/ . ID code A B C D E F G H I J K L Total Political Risk Estimation Component Gorvenment Stability Socioeconomic conditions Investment Profile Internal Conflict External Conflict Corruption Military in Politics Religious Tensions Law and order Ethnic Tensions Democratic Accountability Bureaucracy Quality Maximum Points Hong Kong 12 12 12 12 12 6 6 6 6 6 6 4 100 Somalia 9 10 12 6 4 3 2 3 6 4 5 5 69 3 5 7 12 12 5 6 6 4 6 2 1 69 Rate of return Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Hong Kong -$70,800,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $53,100,000,000 10% Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Somalia -$5,499,400,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $4,399,520,000,000 11% Past year Current year year 1 year 2 year 3 year 4 year 5 1 2 3 4 5 6 7 Japanese Yen 1 1 1 1 1 1 1 Hong Kong HDK 0.0648 0.0708 0.0768 0.0828 0.0888 0.0948 0.1008 Somali SOS 5.6869 5.4994 5.3119 5.1244 4.9369 4.7494 4.5619 Factors affecting cost of capital 1 Business risk; an organization that struggles with a high business risk normally observes low optimal debt ratio 2 Financial flexibility; TEPCO needs to have a strong ability tto raise capital during time of financial this is what is re 3 Dividend policy; a good dividend policy ensures that the organization does not payout too much money 4 capital structure policy; an increment in the cost of equity will be attributed to a equivalent increment in cost of 5 investment policy; investment decisions influence the levels of cost of equity and debt managed by an organizati es low optimal debt ratio f financial this is what is referred to as financial flexibility. too much money alent increment in cost of debt and equity issued. managed by an organization like TEPCO. Rate of return Hong Kong Iniatial -$70,800,000,000 Cashflow 1 $10,620,000,000 Cashflow 2 $10,620,000,000 Cashflow 3 $10,620,000,000 Cashflow 4 $10,620,000,000 Cashflow 5 $10,620,000,000 Purchase $53,100,000,000 IRR 10% NPV $0.00 Somalia Iniatial -$5,499,400,000,000 Cashflow 1 $824,910,000,000 Cashflow 2 $824,910,000,000 Cashflow 3 $824,910,000,000 Cashflow 4 $824,910,000,000 Cashflow 5 $824,910,000,000 Purchase $4,399,520,000,000 IRR 11% NPV $0.01 TEPCO's Investment Decision The best solution would be to investment in somalia inspite of the political risk because this invetsment promises higher re compared to the investment in Hong kong sment promises higher returns and a greater rate of return The other factors that contributed to my decision are 1 Internal rate of return 2 Political Risk ID code A B C D E F G H I J K L Total Political Risk Estimation Component Gorvenment Stability Socioeconomic conditions Investment Profile Internal Conflict External Conflict Corruption Military in Politics Religious Tensions Law and order Ethnic Tensions Democratic Accountability Bureaucracy Quality Maximum Points Hong Kong 12 12 12 12 12 6 6 6 6 6 6 4 100 Somalia 9 10 12 6 4 3 2 3 6 4 5 5 69 3 5 7 12 12 5 6 6 4 6 2 1 69 Rate of return Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Hong Kong -$70,800,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $53,100,000,000 10% Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Somalia -$5,499,400,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $4,399,520,000,000 11% Past year Current year year 1 year 2 year 3 year 4 year 5 1 2 3 4 5 6 7 Japanese Yen 1 1 1 1 1 1 1 Hong Kong HDK 0.0648 0.0708 0.0768 0.0828 0.0888 0.0948 0.1008 Somali SOS 5.6869 5.4994 5.3119 5.1244 4.9369 4.7494 4.5619 Factors affecting cost of capital 1 Business risk; an organization that struggles with a high business risk normally observes low optimal debt ratio 2 Financial flexibility; TEPCO needs to have a strong ability tto raise capital during time of financial this is what is re 3 Dividend policy; a good dividend policy ensures that the organization does not payout too much money 4 capital structure policy; an increment in the cost of equity will be attributed to a equivalent increment in cost of 5 investment policy; investment decisions influence the levels of cost of equity and debt managed by an organizati es low optimal debt ratio f financial this is what is referred to as financial flexibility. too much money alent increment in cost of debt and equity issued. managed by an organization like TEPCO. Rate of return Hong Kong Iniatial -1,000,000,000,000 Cashflow 1 150,000,000,000 Cashflow 2 150,000,000,000 Cashflow 3 150,000,000,000 Cashflow 4 150,000,000,000 Cashflow 5 150,000,000,000 Purchase 750,000,000,000 IRR 10% NPV ($7,296,851,862.18) Somalia Iniatial -$1,000,000,000,000 Cashflow 1 $150,000,000,000 Cashflow 2 $150,000,000,000 Cashflow 3 $150,000,000,000 Cashflow 4 $150,000,000,000 Cashflow 5 $150,000,000,000 Purchase $800,000,000,000 IRR 11% NPV $0.00 TEPCO's Investment Decision The best solution would be to investment in somalia inspite of the political risk because this invetsment promises higher re compared to the investment in Hong kong sment promises higher returns and a greater rate of return The other factors that contributed to my decision are 1 Internal rate of return 2 Political Risk ID code A B C D E F G H I J K L Total Political Risk Estimation Component Gorvenment Stability Socioeconomic conditions Investment Profile Internal Conflict External Conflict Corruption Military in Politics Religious Tensions Law and order Ethnic Tensions Democratic Accountability Bureaucracy Quality Maximum Points Hong Kong 12 12 12 12 12 6 6 6 6 6 6 4 100 Somalia 9 10 12 6 4 3 2 3 6 4 5 5 69 3 5 7 12 12 5 6 6 4 6 2 1 69 Rate of return Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Hong Kong -$70,800,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $53,100,000,000 10% Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Somalia -$5,499,400,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $4,399,520,000,000 11% Past year Current year year 1 year 2 year 3 year 4 year 5 1 2 3 4 5 6 7 Japanese Yen 1 1 1 1 1 1 1 Hong Kong HDK 0.0648 0.0708 0.0768 0.0828 0.0888 0.0948 0.1008 Somali SOS 5.6869 5.4994 5.3119 5.1244 4.9369 4.7494 4.5619 Factors affecting cost of capital 1 Business risk; an organization that struggles with a high business risk normally observes low optimal debt ratio 2 Financial flexibility; TEPCO needs to have a strong ability tto raise capital during time of financial this is what is re 3 Dividend policy; a good dividend policy ensures that the organization does not payout too much money 4 capital structure policy; an increment in the cost of equity will be attributed to a equivalent increment in cost of 5 investment policy; investment decisions influence the levels of cost of equity and debt managed by an organizati es low optimal debt ratio f financial this is what is referred to as financial flexibility. too much money alent increment in cost of debt and equity issued. managed by an organization like TEPCO. Rate of return Hong Kong Iniatial -$70,800,000,000 Cashflow 1 $10,620,000,000 Cashflow 2 $10,620,000,000 Cashflow 3 $10,620,000,000 Cashflow 4 $10,620,000,000 Cashflow 5 $10,620,000,000 Purchase $53,100,000,000 IRR 10% NPV $0.00 Somalia Iniatial -$5,499,400,000,000 Cashflow 1 $824,910,000,000 Cashflow 2 $824,910,000,000 Cashflow 3 $824,910,000,000 Cashflow 4 $824,910,000,000 Cashflow 5 $824,910,000,000 Purchase $4,399,520,000,000 IRR 11% NPV $0.01 TEPCO's Investment Decision The best solution would be to investment in somalia inspite of the political risk because this invetsment promises higher re compared to the investment in Hong kong sment promises higher returns and a greater rate of return The other factors that contributed to my decision are 1 Internal rate of return 2 Political Risk ID code A B C D E F G H I J K L Total Political Risk Estimation Component Gorvenment Stability Socioeconomic conditions Investment Profile Internal Conflict External Conflict Corruption Military in Politics Religious Tensions Law and order Ethnic Tensions Democratic Accountability Bureaucracy Quality Maximum Points Hong Kong 12 12 12 12 12 6 6 6 6 6 6 4 100 Somalia 9 10 12 6 4 3 2 3 6 4 5 5 69 3 5 7 12 12 5 6 6 4 6 2 1 69 Rate of return Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Hong Kong -$70,800,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $10,620,000,000 $53,100,000,000 10% Iniatial Cashflow 1 Cashflow 2 Cashflow 3 Cashflow 4 Cashflow 5 Purchase IRR Somalia -$5,499,400,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $824,910,000,000 $4,399,520,000,000 11% Past year Current year year 1 year 2 year 3 year 4 year 5 1 2 3 4 5 6 7 Japanese Yen 1 1 1 1 1 1 1 Hong Kong HDK 0.0648 0.0708 0.0768 0.0828 0.0888 0.0948 0.1008 Somali SOS 5.6869 5.4994 5.3119 5.1244 4.9369 4.7494 4.5619 Factors affecting cost of capital 1 Business risk; an organization that struggles with a high business risk normally observes low optimal debt ratio 2 Financial flexibility; TEPCO needs to have a strong ability tto raise capital during time of financial this is what is re 3 Dividend policy; a good dividend policy ensures that the organization does not payout too much money 4 capital structure policy; an increment in the cost of equity will be attributed to a equivalent increment in cost of 5 investment policy; investment decisions influence the levels of cost of equity and debt managed by an organizati es low optimal debt ratio f financial this is what is referred to as financial flexibility. too much money alent increment in cost of debt and equity issued. managed by an organization like TEPCO. Rate of return Hong Kong Iniatial -1,000,000,000,000 Cashflow 1 150,000,000,000 Cashflow 2 150,000,000,000 Cashflow 3 150,000,000,000 Cashflow 4 150,000,000,000 Cashflow 5 150,000,000,000 Purchase 750,000,000,000 IRR 10% NPV ($7,296,851,862.18) Somalia Iniatial -$1,000,000,000,000 Cashflow 1 $150,000,000,000 Cashflow 2 $150,000,000,000 Cashflow 3 $150,000,000,000 Cashflow 4 $150,000,000,000 Cashflow 5 $150,000,000,000 Purchase $800,000,000,000 IRR 11% NPV $0.00 TEPCO's Investment Decision The best solution would be to investment in somalia inspite of the political risk because this invetsment promises higher re compared to the investment in Hong kong sment promises higher returns and a greater rate of return The other factors that contributed to my decision are 1 Internal rate of return 2 Political Risk