An Italian company is considering expanding the sales of its cappuccino machines

Question

An Italian company is considering expanding the sales of its cappuccino machines to the U.S market. As a result, the idea of a setting up a manufacturing facility in the U.S should be explored. The company estimates the initial demand in U.S will bring in an annual operating profit of $2,500,000, which is expected to keep track with the U.S price level. The new facility will free up the amount currently exported to the U.S market. The company presently realizes an annual operating profit of €1,000,000 on its U.S. export.

The manufacturing facility is expected to cost $24 million. The company plans to finance the project with a combination of debt and equity capital. The new project will increase the company’s borrowing capacity by €10 millionand the company plans to borrow only that amount. The city in which the facility will be built has promised to provide a 5-year loan of $ 7.5 million at 6% per annum.

The U.S IRS will allow the company to straight-line depreciates the new facility over a 5-year period. After that time, the company plans to sell all molding equipment (accounts for 55% of the project’s cost). Although it is difficult to estimate the salvage value, the company is confident that the after-tax salvage value will be at least 25% of the original book value.

Corporate tax rates in the U.S and Italy are the same as 35%. The long-term inflation rate is expected to be 3% in the U.S and 5% in Italy. The current spot exchange rate is $ 1.5/€. The Italian company explicitly believes in PPP as the best means to forecast future exchange rate.

The company’s U.S sales affiliate currently holds $1.5 million ready for repatriation back to Italy. The money was accumulated under a special tax concession rate of 25%. If the fund were repatriated, additional tax will be due.

The company estimates its weighted average cost of capital to be 11%, and all-equity cost of capital to be 15%. It can borrow dollars at 9% per annum and Euros at 10%.

THERE ARE TOTALLY NINE QUESTIONS!!!!!!!!!!!!!!!!!!!

(1) Why APV model is better than NPV model for capital budgeting analysis?

(2) Specify the discount rate you would use for the calculation of (1) present value (PV) of after-tax operating cash flows; (2) PV of depreciation tax shield; (3) PV of terminal cash flows. Explain why.

(3)Illustrate how to calculate the PV of after-tax operating cash flow in APV analysis (use the first two years in your illustration).

(4)Discuss how the U.S manufacturing facility should be financed. Specify the amount of debt and cost of debt.

(5)Calculate the subsidy provide by the host city.

(6)Calculate the PV of interest tax shield from non-concessionary loan.

(7)Calculate the amount of fund that will be freed up by the new project.

(8)Assume the preliminary estimate of the 5-year project’s APV is -€1,000,000which does not include the after-tax salvage value of the equipment. Calculate the break-even after-tax salvage value. Do you recommend the project to the Italian company? Explain.

(9)Now assume the concessionary loan offered by the host city increases to $20 million. How much of the interest payment should be used to calculate interest tax shield? Explain.

Explanation / Answer

1) Why APV model is better than NPV model for capital budgeting analysis?

Answer:

Adjusted present value (APV), defined as the net present value of a project if financed solely by equity plus the present value of financing benefits, is another method for evaluating investments. It is similar to NPV. The difference is that is uses the cost of equity as the discount rate rather than WACC. And APV includes tax shields such as those provided by deductible interests. APV analysis is effective for highly leveraged transactions.

(2) Specify the discount rate you would use for the calculation of (1) present value (PV) of after-tax operating cash flows; (2) PV of depreciation tax shield; (3) PV of terminal cash flows. Explain why.

Answer:

We have to use equity cost as a discount rate which is 15% for the calculation of discount rate. The reason being for the calculation of APV we need to first see the impact of cost of equity on present values.

(3)Illustrate how to calculate the PV of after-tax operating cash flow in APV analysis (use the first two years in your illustration).

Answer:

After tax cash flows can be calculated as:

Operating profit = $2,500,000

Interest on five year loan = 6% x $7.5 million = $450,000

Investment in new facility = $24 million

Depreciation on new facility (by SLD) = $24 million /5 = $4.8 million

Corporate tax rate in USA = 35%

Therefore depreciation tax shield = 35% x $4.8 million = $1.68 million

And interest tax shield = 35% x $450,000 = $157,500

Therefore,

After tax cash flows = $2,500,000 + $157,000 + $1,680,000 = $4,337,500

Present value of these cash flows at 9% discount rate :

PV = $7,630,144.77

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