REVIEW QUESTIONS ON CAPITAL BUDGETING QUESTION 1 Mr. Muwanga is a Ugandani investor who is considering investing in Tanzanian market. A local consultancy firm in Dar es Salaam provided the following information to him. i) Initial investment will be TZS 200 million in year 0 ii) After tax expected cash flows in TZS from year 1 to 4 will be (millions): 100, 125, 150 and 150. iii) Ugandan cost of capital is 16% and income Tax on foreign income is 35% on Ugandan shillings. iv) The current spot rate is 0.560 TZS/1.00UGS v) The Uganda risk free rate is 6%, while it is 9% in Tanzania. Required: a) Determine the expected spot rate of exchange for the next four years between the TZS and the UGS b) Evaluate the investment proposal to Mr. Muwanga using the Net Present Value approach. QUESTION 2 DINGI Corp. is a U.S. based Multinational Corporation (MNC), with a subsidiary in Tanzania that produces and sells farm equipment. DINGI believes that they can also develop an equipment repair business in Tanzania, which will cost the company Tshs. 10 billion. Market study further indicates the following: The business will generate cash flows estimated at TShs. 5 billion, 8 billion, 7 billion, 9 billion and 6 billion for each year respectively for a period for 5 years. Assume the government imposes no taxes on income earned by the business. However, it does impose a withholding tax of 15% on any funds remitted to the parent company. The U.S. government will tax any US$ earnings received by the parent company from the subsidiary company at the rate of 20%. The required rate of return on the project is 24%. This rate is dependent on existing economic conditions, the firm’s capital structure, and the project’s risk. The host government will acquire the business in the 5th year with little compensation of Tshs. 50 million to DINGI. The T.shs. value to US$ is expected to vary as follows: Year 0 1 2 3 4 5 Rate 1000 1000 1080 1050 1100 1100 You are an investment analyst and the company has approached you for your advice. REQUIRED: Evaluate the attractiveness of the project from both subsidiary and parent’s perspectives and advice the management of DINGI on whether the investment should be undertaken. QUESTION 3 Hollender Company is a South-African based manufacturer of kitchen furniture. The company’s senior management has believed for several years that there is little opportunity to increase sales in the domestic market and wish to set up a manufacturing subsidiary in Tanzania. Because of high transportation costs, exporting from South Africa is not financially viable. The Tanzania subsidiary would involve itself in the construction of a new factory in Dar es Salaam. The projected costs are shown below:- Land Building Machinery Initial Investment in Working Capital Now Tshs ‘000’ 23,000 16,000 15,000 Year 1 Tshs. ‘000’ 62,000 64,000 - Production and sales in year two are estimated to be 2,000 kitchen furniture at an average price of Tshs. 200,000 (at current prices). Production and sales in each of years 3 – 5 is forecast at 2,500 units. Total local variable costs in Tanzania in year two are expected to be Tshs. 110,000 per unit (at current prices). No tax allowable depreciation exists on fixed assets. All prices and costs in Tanzania are expected to increase annually by the current rate of inflation. The after tax realizable value of the investment in five years’ time is expected to be approximately Tshs. 162 million at price levels then rulling. Inflation for each of the next six years is expected to be: South Africa 3% Tanzania 5% The cost of capital for the company is 10%. The spot exchange rate is Tshs. 50/SAR. Corporate tax in Tanzania is 30%, in SA 40%. Taxation is payable, and allowances are available, one year in arrears. The government of Tanzania is anxious to encourage foreign investment and thus allows overseas investors to repatriate an annual cash dividend equal to that year’s after tax accounting profit. Cash remitted at South Africa from the subsidiary is not taxable in South Africa. REQUIRED Evaluate whether the Tanzanian Subsidiary should be established by Hollender Company. QUESTION 4 Kipanga Corporation currently has no existing business in German but it is considering establishing a subsidiary there. The following information has been gathered to assess this project. The initial investment capital required to start the project would be Euro 50 million to be used to buy plant and equipment. The plant is expected to have useful life of 10 years and would be depreciated using a straight line method. The project would be terminated at the end of year three, when the subsidiary would be sold. Kipanga expected to receive Euro QUESTION 5 A US based Multinational Company is considering the establishment of a two year project in Japan with a US$ 8 million initial investment. The company’s cost of capital is 12 percent. The required rate of return on this project is 18 percent. The project with no salvage value after two years is expected to generate net cash flows of Yen 12 million in years 1 and Yen 30 million in year 2. Assume no taxes and a stable exchange rate of US $ 0.60 per Japanese Yen. REQUIRED: What is the net present value of the project in dollar terms? QUESTION 6 Arrec International Company, a South African company, is considering establishing a manufacturing unit to produce TV sets in Tanzania which has been the main destination an immediate investment outlay of SAR 10 million. The plant is expected to have a useful life of 5 years with no salvage value. For taxation purposes, the company has to follow the straight line method of depreciation. To support the investment in Tanzania an additional working capital of TZS 100,000,000 is needed. Other relevant information on the project follows: Land Production per annum Variable cost per unit Raw materials per unit Labour Overheads Other fixed Costs per annum Selling price per Unit TZS 8,000,000 1,000 units TZS 200,000 of which: TZS 50,000 TZS 100,000 TZS 50,000 TZS 200,000,000 TZS 700,000 The south African Company is subjected to 30% corporate tax rate in Tanzania and its cost of capital is s20 per cent. The exchange rate between the TZS and SAR has been very volatile due to unstable interest rate policies in the two countries. The current exchange rate between the TZS and the SAR is TZS 50/SAR. Interest rates are expected to be as follows in the next five years: YEAR 1 2 3 TANZANIA 5% 7% 6% SOUTH AFRICA 6% 6% 5% 4 5 8% 10% 6% 8% South Africa imposes no taxes on cash profit remitted from abroad. REQUIRED: (a) Assuming that all profits can be repatriated, advice Arrec regarding the financial viability of the proposal. (b) Capital budgeting analysis for a foreign project, like the one proposed by Arrec International Co. above, is considerably more complex than the domestic case. i. e. if the company were to invest in its domestic country. Outline the main reasons contributing to increased complexity in valuating foreign projects.
