Question
Steele Corp., a U.S. company, plans to establish a subsidiary in Australia.An initial investment of A$53 million is required for the Australian subsidiary. The Australian
Steele Corp., a U.S. company, plans to establish a subsidiary in Australia.An initial investment of A$53 million is required for the Australian subsidiary. The Australian government will impose a withholding tax of 12 percent on earnings remitted by the Australian subsidiary. Steele is subject to 35 percent corporate tax in the U. S. As for Steele's subsidiary in Australia, it is subject to 30 percent corporate tax rate. The U.S. government will not impose any taxes on the A$ income. At the end of year 3, the Australian subsidiary expects to receive a salvage value of A$45 million after subtracting capital gains taxes.This amount is not subject to a withholding tax by the Australian government.
For the Australian subsidiary, Steele uses its cost of capital as the project's discount rate. Steele's capital structure is 40 percent debt and 60 percent equity. The after-tax cost of debt and equity for Steele are 10 percent and 25 percent, respectively. The table below provides the relevant information for Steele Corp. at the end of each corresponding year:
Now Year 1 Year2 Year 3
Initial outlay (A$ ) 53,000,000
Cash remitted back (A$) 8,500,000 12,000,000 15,920,000
Salvage value (A$) 45,000,000
Exchange rate estimates ($/A$) 0.50 0.52 0.54 0.56
Forward rate 0.50 0.545 0.55
a. Calculate the US$ amount that Steele Corp would receive at the end of year 1, 2, and 3 assuming that Steele converts the A$ using the exchange rate estimates.
b.Calculate the relevant discount rate for the Australian project and using the cash flows calculated in part (a), determine the net present value (NPV) of this project. Should Steele Corp invest in this project? Why?
c.Suppose, Steele wants to hedge the foreign exchange risk by engaging in the forward contracts. Calculate the NPV the hedged position. Should the company hedge? Why?
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