Question
The MNC has exported its products to this country for almost a decade. A foreign partner now proposes a local joint venture. They ship 50,000
The MNC has exported its products to this country for almost a decade. A foreign partner now proposes a local joint venture. They ship 50,000 units annually at $50 each, with a 10-year import agreement expiring in one year. Pre-tax profit per unit is $15 (see Table 1), and unit sales grow at a 6.3% rate matching the GDP growth.
Table 1. Cost Breakdown of the Product (Exported)
Cost Type | Cost per Unit |
Components | $20 |
Labor Cost | $10 |
Freight and Insurance | $5 |
Total Cost | $35 |
After discussions with the foreign partner, a $3 million startup cost in local currency was estimated at an exchange rate of $1 = 7.2869138. The foreign partner committed to covering 50% of this cost, with an additional $500,000 needed for working capital.
Under the tentative joint venture terms, the foreign partner would manage daily operations, overseen by your chief engineer. After 7 years, the MNC would hand over operations, receiving full reimbursement of working capital and a purchase price equal to 125% of the fixed assets' net book value. MNCs could remit their share of annual cash flows to the US at prevailing exchange rates.
For tax purposes, fixed assets could depreciate over 10 years, with a 25% local corporate tax rate and a 21% US federal corporate tax rate. The product cost structure (see Table 2) included a mix of domestic and US components, with US components' net cost at $5 per unit, supplied by the joint venture at $8 per unit, offering significant cost advantages.
Table 2. Cost Breakdown of the Product Manufactured in the Country
Cost Type | Cost per Unit |
Domestic Components | $12 |
Imported Components | $8 |
Labor Cost | $5 |
Total Cost | $25 |
You inquired about whether it's more advantageous for the MNC to raise funds locally at 3.45% per year or borrow in the US at 5.5% and then convert the funds at the prevailing exchange rate before remitting them to the country.
The assistant indicated that, assuming similar transaction costs and no significant impediments in either country, there should be no real advantage either way based on covered interest arbitrage principles.
You know that the required rate of return on projects of this nature is typically 15% in the US. However, you learned that the nominal risk-free rate in the country is 2.8150% calculated by adding the yield on the 10-year bond. The U.S. inflation rate, using the same calculation method is 8.3889%.
The U.S.A:
Yield | Day | Weekly | Monthly | YoY |
4.6889 | 0.1179
| 0.14% | 0.48% | 1.03% |
The Country:
Yield | Day | Weekly | Monthly | YoY |
2.7150 | 0.0040
| 0.04% | 0.12% | -0.04% |
While the inflation rate is 0.1% in The country and 3.7% in the US. Moreover, it is the MNCs policy to estimate future foreign exchange rates on the basis of projected inflation rates. Accordingly, you had collected inflation rate forecasts for the next seven years for the country and the US.
The U.S.A:
Last | Q4/23 | Q1/24 | Q2/24 | Q3/24 |
3.70 | 3 | 3 | 2.6 | 2.6 |
The Country:
Last | Q4/23 | Q1/24 | Q2/24 | Q3/24 |
0.10 | 0.7 | 1.3 | 2.2 | 2.1 |
Table 5. Projected Annual Inflation Rates
Q1=Y1 | Q2=Y2 | Q2=Y3 | Q3=Y4 | Q3=Y5 | Q4=Y6 | Q4=Y7 | |
US | 3.70% | 5.9% | 12.15% | 18.77% | 25.77% | 33.19% | 41.05% |
The Country | 0.10% | 6.44% | 13.3% | 20.60% | 28.37% | 36.64% | 45.44% |
1.) Make a recommendation using the Home currency method by finding the NPV
Please provide a step-by-step as well as formulas.
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