QUESTION: Evaluate the proposal to move the manufacturing facility from China to Mexico (Appendix 6), using NPV analysis. (25 marks)

Appendix 6: Manufacturing Unit's Business Proposal to Move Production from China to Mexico

The following information has been prepared by a business development team within the manufacturing business segment.

The establishment of a production facility on the outskirts of Mexico City would cost US$480m. 90% of this investment would be payable at the end of year one, with the remainder payable now. The Mexican 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 Mexico within 5 years.

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

A loan facility of US$480m would be established with Bank Mexico 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:

Year 1: reduced labour cost = US$40m; savings on distribution cost = US$20

Year 2: reduced labour cost = US$38m; savings on distribution cost = US$20

Year 3: reduced labour cost = US$36m; savings on distribution cost = US$20

Year 4: reduced labour cost = US$34m; savings on distribution cost = US$20

Year 5: reduced labour cost = US$32m; savings on distribution cost = US$20

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

By relocating to Mexico it is expected that sales demand will increase 20% compound per annum over the 2016 sales units achieved from the China plant. The reduced cost base on relocating to Mexico 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 Fusion), 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 proposal generation.

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

QUESTION: a) Evaluate the proposal to move the manufacturing facility from China to Mexico (Appendix 6), using NPV analysis. (25 marks)

b) Evaluate the decision to use the overall Group cost of capital for the NPV analysis. (10marks)