Question 3

a. The new management is also considering an entirely new investment project, which involves building a new factory in South Korea. The Korean subsidiary will require an initial investment of 157,474m South Korean Won (KRW). Jasmine can borrow money to finance this investment in the UK market, in France, or in South Korea. Appendix Q3.1 offers information about the borrowing costs in different currencies and an estimation of the future value of foreign exchange. Discuss the foreign exchange risk associated with this expansion plan and advise which is the best way to finance the Korean factory.

b. What are the risks related to a potential relocation of the Chinese factory to South Korea?

c. The research department of a large financial institution provided inflation expectations for the next five years. According to the forecasts, the UK will have 1.5% more inflation than France and 3% higher inflation than South Korea. On the basis of this new evidence, would you reconsider your proposal with regard to financing the Korean factory? Explain your answer.

Study material is below.

Appendix Q3.1: Borrowing costs in different currencies and an estimation of the future value of foreign currency exchange

Table 5: Borrowing costs

Initial investment (KRW)	157,474
Interest rate in UK (5-year loan)	0.06
Interest rate in South Korea (5-year loan)	0.14
Interest rate in France (5-year loan)	0.08
Spot exchange rate: KRW per GBP	1,574.74
Expected appreciation of GBP in relation to KRW	4% per annum
Forecasted exchange rate: EUR per GBP	1.16
Expected appreciation of GBP in relation to EUR	2% per annum

Below is material used to answer question 2. This may be of some use answering the question 3.

Appendix Q2.1: Analysis of the child's toy manufacturing (multi-currency)

Table 3: Child's toy manufacturing

	China	China	China	UK	UK	UK	Total	Total	Total
	m	m	m	m	m	m	m	m	m
	2019	2020	2021	2019	2020	2021	2019	2020	2021
Product sold (units)	8,500,000	7,950,000	6,250,000	6,700,000	5,500,000	5,100,000	15,200,000	13,450,000	11,350,000
Turnover	2,178	2,404	2,113	239	200	175	596	582	500
Cost of sales	1,013	1,161	1,088	112	95	89	278	279	256
Admin expenses	370	481	454	41	39	38	102	115	108
Selling & distribution expenses	320	433	423	33	35	35	85	104	100
Operating profit	475	329	148	53	31	13	131	84	36
Interest	0	0	0	6	7	10	6	7	10
Income tax expense	0	0	0	13	8	3	13	8	3
Profit after tax	475	329	148	34	16

Appendix Q2.2: Manufacturing unit's business proposal to move production from China to Vietnam

The establishment of a production facility on the outskirts of Hanoi would cost US$480m. An initial 10% is payable immediately with the remaining 90% payable at the end of year 1. The Vietnamese government incentivises foreign direct investment, with incentives including capital grant funding of up to 50% of the initial capital investment, payable in equal instalments over 5 years, starting in year 1. No writing down allowance is available on any element of the capital expenditure as a result of the capital grant provision. The grant funding is repayable if the company leaves Vietnam within 5 years.

In addition, a working capital investment of US$96m would be required at the outset of the investment. A subsidiary company (Jasmine Vietnam) would be the corporate vehicle through which the company would operate in Vietnam. US$30,000 has already been incurred to date exploring the legal structure of a company in Vietnam.

A loan facility of US$480m would be established with Bank Vietnam to finance the construction of the production facility, with the interest rate cost expected to be 12%. In addition, an overdraft facility of US$100m would be established with an interest rate cost of 15%.

Use the overall Group cost of capital benchmark for investments of this nature of 10% to appraise this capital proposal.

The following plant projections have been provided and are expressed in current terms.

Table 4: Project savings projection

	Year 1	Year 2	Year 3	Year 4	Year 5
	$m	$m	$m	$m	$m
Reduced labour costs	40	38	36	34	32
Savings on distribution costs	20	20	20	20	20

The corporate tax rate for investors in Vietnam is 5% based on sales value for the relevant year and is paid one year in arrears.

By relocating to Vietnam, it is expected that sales demand will increase 20% compound per annum over the 2021 sales units achieved from the China plant. The reduced cost base on relocating to Vietnam is expected to enable a reduced pricing point of US$35 per unit of product (on average), thus generating the additional sales demand. A net margin of 15% is assumed on the additional sales.

An estimate of US$30m per annum (in current terms) has been computed for the allocation of central fixed costs of the parent entity to this activity.

Plant closure and wind down costs of the China facility are expected to be equivalent of US$80m, with 30% payable now, and the balance payable at the end of year 1. As part of the conditions for the original investment in China (and any incentives received by Jasmine), the sale of the plant and associated lands in China cannot be realised until year 3 post cessation of activities. The expected net sales value in year 3 is US$260m. The land in China had an original cost of US$45m.

Ignore inflation.

All transactions have been reflected in US$ as part of the capital generation proposal.

There is no tax impact on transactions included in the NPV analysis associated with the China facility. The capital grant received from the Vietnamese government is not subject to tax in Vietnam.