The International Machine Corporation (IMC) is a large, well-established manufacturer of a wide variety of food processing and packaging equipment. Total revenue for last year was $12 billion, of which 45% was generated outside of the United States. IMC has subsidiaries in 23 countries, with licensing arrangements in 8 others.

The management of IMC is currently contemplating the establishment of a subsidiary in Mexico. IMC has been exporting produces to Mexico for several years, and its international division believes there is sufficient demand for the product and that a Mexican investment might be appropriate at this time. More important, management believes that the Mexican market is expanding, that the economy is growing, and that producing such products locally appears to be consistent with the national aspirations of the Mexican government.

Mexican inflation is projected to be 20% annually, and the U.S. inflation rate is expected to be 10% annually. The current exchange rate is $1 = Ps20 and is expected to remain fixed in real terms over the life of the investment. The following list contains details of the contemplated investment.

A. Initial investment

1. It is estimated that it would take one year to purchase and install plant and equipment.

2. Imported machinery and equipment will cost $9 million. No import duties will be levied by the Mexican government. With a small allowance for banking fees, the bill will come to Ps 95 million.

3. The plant will be set up on government-owned land that will be sold to the project for Ps 6.5 million.

4. IMC plans to maintain effective control of the subsidiary with ownership of 60% of equity. The remaining 40% is to be distributed widely among Mexican financial institutions and private investors. Accordingly, IMC needs to invest U.S. $6 million in the project.

B. Working Capital

1. The company plans to maintain 5% of annual sales as a minimum cash balance.

2. Accounts receivable are estimated to be 73 days of annual sales.

3. Inventory is estimated to be 20% of annual sales.

4. Accounts payable are estimated to be 5% of annual sales.

5. Licensing and overhead allocation fees are paid annually at the end of year.

C. Sales volume

1. Sales volume for the first year is estimated to be 200 units.

2. Selling price in the first year will be Ps 458,000 per unit.

3. Annual unit sales growth of 10% is expected during the project life.

4. An annual price increase of 20% is expected.

D. Cost of goods sold

1. The U.S. parent company is expected to provide parts and components adding up to Ps 59,000 per unit in the first year of operation. These costs (in U.S. dollars) are expected to rise on an average of 10% annually, in line with the projected U.S. inflation rate.

2. Local material and labor costs are expected to be Ps 137,000 per unit, with an annual rate of increase of 20%.

3. Manufacturing overhead (without depreciation) is expected to be Ps 9.2 million the first year of operation. An average rate of increase of 15% is expected.

4. Depreciation of manufacturing equipment is to be computed on a straight-line basis, with a projected life of 10 years and zero salvage value to be assumed.

E. Selling and administrative costs

1. The variable portion of selling and administrative costs is expected to equal 10% of annual sales revenue.

2. Semi-fixed selling costs are expected to equal 5% of the first year's sales. These costs will then rise at 15% annually.

F. Licensing and overhead allocation fees

1. The parent company will levy Ps 23,000 per unit as licensing and overhead allocation fees, payable at year end in U.S dollars.

2. This fee will increase 20% per year to compensate for Mexican inflation.

G. Interest expense

1. Local borrowing can be obtained for working capital purposes at 15%. Borrowing will occur at the end of the year with the full year's interest budgeted in the following year.

2. Any excess funds can be invested in Mexican marketable securities with an annual rate of return of 15%. Investment will be made at the end of the year, with the full year's interest to be received in the following year.

H. Income taxes

1. Corporate taxes in Mexico are 42% of taxable income.

2. Withholding taxes on licensing and overhead fees are 20%.

3. The parent company's effective U.S. tax rate is 22%, which is the rate used in analyzing investment projects. It can be assumed that the parent company can take appropriate credits for taxes paid to, or withheld by, the Mexican government.

I. Dividend payments

1. No dividends will be paid for the first three years.

2. Dividends equal to 70% of earnings will be paid to shareholders, beginning in the fourth year.

J. Terminal payment

It is assumed that, at the end of the tenth year of operations, IMC's share of net worth in the Mexican subsidiary will be remitted in the form of the terminal payment.

K. Parent company's capital structure

1. Domestic debt equals U.S. $1 billion with an average before-tax cost of 12%. The cost of new long-term debt is estimated at 14% before tax.

2. An amount equivalent to $400 million of parent debt is denominated in various foreign currencies, and after adjusting for previous exchange rate gains/losses the cost (or effective cost) of this debt has averaged 16%.

3. Shareholder equity (capital, surplus, and retained earnings) equals U.S. $1.5 billion. The company plans to pay U.S. $3.20 in dividends per share during the coming year. Over the last 10 years, earnings and dividends have grown at a compounded rate of 7%. The market price was $40, and number of shares outstanding were 60 million as of last December 31.

L. Export lost

At present IMC is exporting about 25 units per year to Mexico. If IMC decides to establish the Mexican subsidiary, it is expected that the after-tax effects on income due to the lost export sales would be $648,000, $742,000, and $930,000 in the first three years of operation, respectively. IMC assumes it cannot count on these export sales for more than three years because the Mexican government is determined to see that such machinery is manufactured locally in the near future.

10 points per section

3. Estimate the value of the concessionary loan to the parent.

4. Estimate the value of the lost exports to the parent if this investment is made. Use the parents weighted average cost of capital as the discount rate.