Use the following information to answer the next five questions. (Read the question carefully!)

Wolverine Corp. in Michigan, USA, currently has no existing business in Canada but is considering establishing a subsidiary there. The following information has been gathered to assess this project: The initial investment required is $5 million in Canada dollars (CAD$) for plants and equipment, which are depreciable over the next 10 years. The Exchange rate for CAD is 1.20 (USD/CAD). In addition to the CAD$5 million initial investment for plant and equipment, CAD$2 million is needed for working capital and will be borrowed by the subsidiary from a Canada bank. The Canada subsidiary will pay interest only on the loan each year, at an interest rate of 7 percent. The loan principal is to be paid in 10 years. The project will be terminated at the end of Year 3, when the subsidiary will be sold. The price, demand, and variable cost of the product in Canada are as follows: Year Price Demand Variable Cost 1 CAD$50 40,000 units CAD$3 2 CAD$51 50,000 units CAD$3.5 3 CAD$53 60,000 units CAD$4 The fixed costs, such as overhead expenses, are estimated to be CAD$1 million per year. The exchange rate of the Canada dollar (USD/CAD) is expected to be $1.19 at the end of Year 1, $1.20 at the end of Year 2, and $1.21 at the end of Year 3. The Canada government will impose an income tax of 25 percent on income. In addition, it will impose a withholding tax of 10 percent on money remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes. All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations. The plant and equipment are depreciated over 10 years using the straightline depreciation method. In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the existing Canada loan. The working capital will not be liquidated but will be used by the acquiring firm when it sells the subsidiary. Wolverine expects to receive CAD$6.2 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.

a) Wolverine requires a 20 percent rate of return on this project. What is the NPV of this project?

b) Assume that Wolverine is also considering an alternative financing arrangement, in which the parent would invest an additional fund (in USD) to cover the working capital requirements (2 million CAD) so that the subsidiary would avoid the Canada loan. If this arrangement is used, the selling price of the subsidiary (after subtracting any capital gains taxes) is expected to be CAD$1.8 million higher. However, this money (1.8 million) will be subject to withholding tax. (6.2 million is still not taxable.) What is the NPV of the project if this alternative financing is implemented?

c) Assume Wolverine used the original financing proposal and that funds are blocked This interest income is not subject to the income tax of 25%. No tax on this interest income except for the withholding tax. What is the projects NPV with government blocking fund?

d) Assuming that there is not government restriction and company does not use the alternative financing (i.e., original case), what is the break even salvage value? That is the SV that makes the NPV zero?

e) After one year of operation, company received an offer of 6 million CAD for the company. The buyer will assume the loan and take over the working capital (SWAP) and the 6 million will be after all the tax including withholding tax and capital gains tax. Tax treaty will be applied and US tax is also exempted. It is good offer and the company should accept this offer. True of False.

True

False