Capital budgeting for a multinational project
Due: June 18, 2016
This project can be done individually or with a group of your choosing (it need not be the same group that you did the first project with). If you work with others, all group members must contribute to the analysis. Only a single submission should be made for the group but be sure that it identifies all group members. All group members will receive the same score on this project.
Project: Analyze the capital budgeting decision that Spec Equipment, Inc. faces relative to the proposed Kenya project described below. (The following pages provide all the information you need about the project.)
1. Forecast expected cash flows for the project (Spec Kenya).
2. Determine the IRR of the project.
3. Forecast expected cash flows for Spec Equipment.
4. Determine the weighted average cost of capital for Spec Equipment.
5. Determine the net present value of Spec Equipment’s investment in the project. (Note that you do not need to compute the NPV of the project itself or any foreign equity owner’s value).
Submit a spreadsheet illustrating all cash flows for the project and for Spec Equipment, and showing the IRR for the project; and the NPV and IRR for Spec Equipment, a statement indicating whether Spec should undertake the project, and a brief explanation of the reason for that conclusion.
Spec Equipment, Inc.: Kenya Project
Spec Equipment Inc. manufactures a wide range of machinery for a diverse group of industries. Its average annual revenue for the last five years is $12.5 billion. It is currently considering establishing a subsidiary in Kenya. It has developed relationships with Kenyan firms in several industries and believes that it can increase its penetration of the African market with a local presence. It also hopes to benefit from expected expansion of economies in a number of African states.
Spec Equipment will own 80% of the Kenyan subsidiary with the balance owned by local firms and nationals, all of which have interests coincident with Spec. Except as specifically noted, all net cash flows are divided pro-rata among the owners.
Initial plant and equipment
The subsidiary has contracted to purchase land for its manufacturing facility from the Kenyan government for KSh700 million. Construction will cost $10 million and equipment, $70 million. The entire cost of the land and half of the plant and equipment cost will be paid at the beginning of construction (time 0) and the other half at the end (time 1). The subsidiary expects it can bring the plant on-line one year after the start of construction. Depreciation of equipment under Kenyan tax law will be straight-line over a 10 year life; construction cost depreciates straight-line over a 20 year life, both with no salvage value.
The subsidiary will maintain a cash balance equal to 5% of expected sales for the following year and inventory of 75 days of expected next year’s sales. It will carry accounts receivable equal to 25% of sales from the prior year, and accounts payable equal to 30% of the prior year’s sales.
Spec will operating the project for 11 years (time 2 through time 12). Spec expects the subsidiary’s sales to be 630 units in the first operating year (time 2), with units sold increasing 18% per year. The initial per unit sales price will be KSh3.9 million and price will increase with Kenyan inflation estimated at 6.5% per year.
Spec provides components parts to the project at $5850 per unit in the first year of operations. This price will increase with US inflation, estimated to average 1.5% per year. Local materials and labor are expected to cost KSh1.15 million per unit and increase with Kenyan inflation. Manufacturing overhead is expected to be KSh130.5 million in the first year and increase 7.5% per year. Variable costs of sales will equal 9.5% of sales revenue, and semi-variable costs, 12% of the first year’s sales. Semi-variable costs increase 15% per year.
The subsidiary will pay Spec Equipment an overhead allocation and marketing fee (for parent firm marketing, management and accounting services provided to the subsidiary) firm equal to $2,340 per unit. This fee will increase annually with U.S. inflation.
The subsidiary will borrow all funds necessary for working capital from local lenders at an interest rate of 13% per year. Interest is payable annually at year end and working capital loans will be rolled over (and increased or decreased as required) annually.
Excess funds (cash flows not distributed to owners) are invested at each year end and earn interest at 13%. Interest is paid annually.
The project will pay corporate income taxes in Kenya at 37.5%. Spec will pay no additional US income tax on project cash flows distributed to it.
Kenya imposes a withholding tax of 10% on distributions from project in Kenya to foreign owners. That tax will apply to the overhead allocation and license fee and dividends paid to Spec. In addition, Spec will pay an additional US tax of 25% on the overhead allocation and license fee received from the subsidiary.
Kenya will not permit the subsidiary to pay any dividends for the first five years of operations. During that time all excess funds will be invested. Beginning at time 7, the company will pay 75% of its earnings (not cash flow) as dividends, allocated pro-rata among its owners, i.e., 80% to Spec. All cash flows not distributed will be invested.
At the end of year 12, the subsidiary will terminate the project, sell its assets for an expected net after tax cash flow of KSh700 million, and distribute that amount together will all accumulated investment funds to the owners on a pro-rata basis.
Replacement of Exports by Spec Equipment
Production by the subsidiary in Kenya is expected to replace exports Spec Equipment would otherwise realize causing Spec’s after-tax cash flow to decline as follows: year 2, $810 thousand; year 3, $650 thousand; year 4, $480 thousand; and year 5, $450 thousand.
Spec Equipment Capital Structure an required return
Spec presently has domestic debt of $1.75 billion with a before tax cost of the debt is 9% $600 million in foreign currency debt with a before tax average cost of 12.5%. New debt is expected to cost 10%.
Spec has 80 million shares outstanding with a current per share price is $70.91 per share. The firm expects to pay dividends in the next year equal to $3.90 per share. Over the last several years, dividends have increased 8.5% per year and the company expects that rate of increase to continue into the future.
Spec will fund its investment in the subsidiary (80% of the project initial investment) using equity and new debt in the same proportion as its current capital structure.
Kenyan currency, the Kenyan shilling (KES) currently trades at KSh101.096 per U.S. dollar.
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