PROBLEM 1 (Multinational Transfer Pricing and Tax Considerations) Smith Corporation, headquartered in Canada, manufactures state-of-the-art milling machines. It has two marketing subsidiaries, one in the United States and one in Mexico that sell its products. Smith is building one new machine, at a cost of $500,000. There is no market for the equipment in Canada. The equipment can be sold in the United States for $1,000,000, but the United States subsidiary would incur transportation and modification costs of $200,000. Alternatively, the equipment can be sold in Mexico for $950,000, but the Mexican subsidiary would incur transportation and modification costs of $250,000. The Canadian company can sell the equipment to either its United States subsidiary or its Mexican subsidiary but not both. The Smith Corporation and its subsidiaries operate in a very decentralized manner. Managers in each company have considerable autonomy, with each manager interested in maximizing company income. REQUIRED: a) From the viewpoint of Smith and its subsidiaries taken together, should the Smith Corporation manufacture the equipment? If it does, where should it sell the equipment to maximize total operating income? (Ignore any tax effects.) b) What is the minimum transfer price that the Smith Corporation (Canada) would be willing to accept independently of the subsidiaries? c) What are the maximum transfer prices that the United States and Mexican subsidiaries would be willing to accept independently of each other? d) The effective tax rates for this transaction are as follows: 40% in Canada, 65% in United States, and 10% in Mexico. The tax authorities in the three countries are uncertain about the cost of the intermediate product and will allow any transfer price between $500,000 and $710,000. If Smith and its subsidiaries want to maximize after-tax operating income, where should the equipment be transferred to and at what price? e) Now suppose managers act autonomously to maximize their own company's after-tax operating income. The tax authorities will allow transfer prices only between $500,000 and $710,000. Which subsidiary will get the product and at what price? PROBLEM 1 (Multinational Transfer Pricing and Tax Considerations) Smith Corporation, headquartered in Canada, manufactures state-of-the-art milling machines. It has two marketing subsidiaries, one in the United States and one in Mexico that sell its products. Smith is building one new machine, at a cost of $500,000. There is no market for the equipment in Canada. The equipment can be sold in the United States for $1,000,000, but the United States subsidiary would incur transportation and modification costs of $200,000. Alternatively, the equipment can be sold in Mexico for $950,000, but the Mexican subsidiary would incur transportation and modification costs of $250,000. The Canadian company can sell the equipment to either its United States subsidiary or its Mexican subsidiary but not both. The Smith Corporation and its subsidiaries operate in a very decentralized manner. Managers in each company have considerable autonomy, with each manager interested in maximizing company income. REQUIRED: a) From the viewpoint of Smith and its subsidiaries taken together, should the Smith Corporation manufacture the equipment? If it does, where should it sell the equipment to maximize total operating income? (Ignore any tax effects.) b) What is the minimum transfer price that the Smith Corporation (Canada) would be willing to accept independently of the subsidiaries? c) What are the maximum transfer prices that the United States and Mexican subsidiaries would be willing to accept independently of each other? d) The effective tax rates for this transaction are as follows: 40% in Canada, 65% in United States, and 10% in Mexico. The tax authorities in the three countries are uncertain about the cost of the intermediate product and will allow any transfer price between $500,000 and $710,000. If Smith and its subsidiaries want to maximize after-tax operating income, where should the equipment be transferred to and at what price? e) Now suppose managers act autonomously to maximize their own company's after-tax operating income. The tax authorities will allow transfer prices only between $500,000 and $710,000. Which subsidiary will get the product and at what price
