It is the end of the year, and Ace, Inc., a US company, has been approached by L

Question

It is the end of the year, and Ace, Inc., a US company, has been approached by Lakson Group, a company from Pakistan, to explore the possibility of a joint venture in Pakistan to produce widgets. This year, Ace exported 100,000 widgets to Pakistani importer SS Import-Export Co. at 5,000 Pakistan rupees (PKR) each. The spot exchange rate is 100 PKR per $1. Each widget costs Ace $30 to produce and ship to Pakistan. Ace estimates that from now on widget sales in Pakistan will increase at a 5% annual rate.

Production of widgets in Pakistan requires the construction of a plant which, at the prevailing spot exchange rate, has an immediate cost of $6,000,000 to be equally shared by the two firms. The plant could be depreciated on a straight-line basis over 8 years. In addition, it is estimated that at the prevailing spot exchange rate each partner must contribute $500,000 of net working capital right away to launch the joint venture. The total cost of production in Pakistan is currently estimated to be 2300 PKR per widget and is expected to remain unchanged over the following five years. Part of this cost is for components produced by Ace in the US, at a cost of $5, and then supplied to the joint venture plant in Pakistan at $7 per widget. SS Import-Export has agreed to buy the widgets produced in Pakistan over the next five years at the same price it currently pays to import them from the US. The applicable tax rate in Pakistan, and in the US, is 35%.

Five years after the joint venture is established, Ace will pull out and in return it will recover in full its investment in net working capital and it will also sell its share of the plant to Lakson for an amount equal to 110% of its share of the plant’s book value at that time. To promote investment by US firms in Pakistan, the US government has agreed that the sale of Ace’s share of the plant to Lakson five years from now has no tax implications. In addition, the Pakistani government has agreed that at the end of each of the next five years Ace may remit its share of the joint venture’s net cash flows to the US at the prevailing exchange rate.

You are in charge of evaluating the joint venture for Ace. You believe that projects similar to that in the joint venture would require a 12% rate of return if undertaken in the US. Further, your assistant has provided the following input about the projected inflation rates over the next five years:

1. Provide calculations using the “foreign country approach” and the “home country approach”.

Year

1

2

3

4

5

US

1%

1%

2%

2%

2%

Pakistan

3%

4%

6%

6%

6%

Year

1

2

3

4

5

US

1%

1%

2%

2%

2%

Pakistan

3%

4%

6%

6%

6%

Explanation / Answer

Cost of the plant = $6,000,000 Depreciation on straight line basis = $750,000 Initial contribution to working capital = $500,000 Cost of production per widget = 2300 PKR This year: Units sold this year = 100,000 Sale price per unit = 5000 PKR Cost per unit of widget = $30 Increase in sales per year = 5% Tax Rate = 35% Exchange rate = 100 PKR per USD (in PKR) Year 0 1 2 3 4 5 Initial Investment $6,000,000 Contribution to working capital $500,000 Revenues 500000000 525000000 551250000 578812500 607753125 Costs 230000000 230000000 230000000 230000000 230000000 Depretiation 75000000 75000000 75000000 75000000 75000000 Operating profit 195000000 220000000 246250000 273812500 302753125 Tax (35%) 68250000 77000000 86187500 95834375 105963594 Earning after tax 126750000 143000000 160062500 177978125 196789531 Cash flow 201750000 218000000 235062500 252978125 271789531 Total cash flows -650000000 201750000 218000000 235062500 252978125 271789531 Discount rate = 12% Therefore, NPV of the Joint Venture = 186227889.4 PKR or $ 1,862,278.89 For the calculation of the NPV before the Joint Venture: Year 0 1 2 3 4 5 Revenues 500000000 500000000 525000000 551250000 578812500 Cost 300000000 300000000 300000000 300000000 300000000 Operating Profit 200000000 200000000 225000000 251250000 278812500 Tax (35%) 70000000 70000000 78750000 87937500 97584375 Cash Flows 130000000 130000000 146250000 163312500 181228125 Doiscount rate = 12% Therefore, NPV of the pre joint venture deal = $5,304,262.45 Which is much higher than The Joint venture valuation.

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