Question 1 Wolverine Corp. currently has no existing business in New Zealand but
ID: 2796133 • Letter: Q
Question
Question 1 Wolverine Corp. currently has no existing business in New Zealand but is considering establishing a subsidiary there. The following information has been gathered to assess this project: • The initial investment required is 50 million in NZDs (NZD). Given the existing spot rate of USD .50 per NZD, the initial investment in USDs is USD 25 million. The project will be terminated in 3 years. • Wolverine plans to finance the new investment by borrowing NZD 2 million from the local market. The New Zealand subsidiary will pay 5% percent. The loan will be fully paid in 3 years. Assume that the NZ subsidiary do not need any additional working capital. • Assuming integrated capital market, the risk free rate in the US is 4%, the equity risk premium is 5% and beta of the project is 0.95. The equity financing is 60% and debt financing is 40% for the project. • The project will be terminated at the end of Year 3, when the subsidiary will be sold. Wolverine expects to receive NZD 52 million. Assume that this amount is not subject to a withholding tax. • The price, demand, and variable cost of the product in New Zealand are as follows: Year Price Demand Variable Cost 1 NZD 500 40,000 units NZD 30 2 NZD 511 50,000 units NZD 35 3 NZD 530 60,000 units NZD 40 * The fixed costs, such as overhead expenses, are estimated to be NZD 6 million per year. * The exchange rate of the NZD is expected to be USD .52 at the end of Year 1, USD .54 at the end of Year 2, and USD .56 at the end of Year 3. * The New Zealand government will impose an income tax of 20 % on income. The US corporate income tax is 35 %. Any cash flow sent by the subsidiary is subject to 5% withholding tax. * 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 NZD 6,000,000 and depreciated over 3 years using the straight line depreciation method. a) Estimate WACC for the project. b) Calculate the NPV & IRR from the perspective of the subsidiary. c) Calculate the NPV & IRR from the perspective of the parent. d) Should Wolverine Corp accept this project? If not explain what could the parent company do?
Explanation / Answer
Ans:
1. WACC of the project
To compute the WACC of the project we need to calculate the cost of debt and equity:
Before tax cost of debt =5%
Tax rate- 25% (including withholding tax)
Debt component in capital structure-40%
Cost of debt= Wd* Cd*(1-t)
Equity component in capital structure- 60%
Cost of equity= RFR+ Beta (Rm)- RFR)
RFR- Risk Free Rate= 4%
Risk premium- 5%
So, Market rate- 9%
Beta- 0.95
Cost of equity= 0.04+((0.95*(0.09)- 0.04)
Ce= 0.0855
WACC= Wd* Cd*(1-t)+ Wd*Ce
WACC= 0.40*0.05(1-0.25) + 0.60*0.0855
WACC= 0.015+0.0513= 0.0663 or 6.63%
b. The NPV and IRR calculation is given below. Considering the only investment in plant and machinery of NZD 6 million from subsidiary’s perspective NPV and IRR both are positive. However the NPV and IRR both are negative taking into account the total investment cost from parent’s perspective.
c. NPV and IRR calculation from parent’s perspective
Year
0
1
2
3
Investment
50000000
Revenue
20000000
25550000
31800000
Variable cost
1200000
1750000
2400000
Fixed cost
6000000
6000000
6000000
EBIDTA
12800000
17800000
23400000
Depreciation
2000000
2000000
2000000
Interest cost
1000000
1000000
1000000
Profit before tax
9800000
14800000
20400000
Tax@20%
1960000
2960000
4080000
Withholding tax@5%
490000
740000
1020000
Profit after Tax
7350000
11100000
15300000
Add depreciation
2000000
2000000
2000000
Project Cashflows
-50000000
9350000
13100000
17300000
Discounting Rate
9%
NPV
-17037236.23
IRR
-10%
Wolverine Corp should not accept the project as the NPV and IRR both are negative which means that the project is not viable and it would not add any positive value to the corporation. The company should drop this project.
Year
0
1
2
3
Investment
50000000
Revenue
20000000
25550000
31800000
Variable cost
1200000
1750000
2400000
Fixed cost
6000000
6000000
6000000
EBIDTA
12800000
17800000
23400000
Depreciation
2000000
2000000
2000000
Interest cost
1000000
1000000
1000000
Profit before tax
9800000
14800000
20400000
Tax@20%
1960000
2960000
4080000
Withholding tax@5%
490000
740000
1020000
Profit after Tax
7350000
11100000
15300000
Add depreciation
2000000
2000000
2000000
Project Cashflows
-50000000
9350000
13100000
17300000
Discounting Rate
9%
NPV
-17037236.23
IRR
-10%
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