Question

An Italian company is considering expanding the sales of its cappuccino machines to the U.S market....

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 million,and 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 -€1,000,000,which 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.

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Answer #1

1. APV model is better than NPV due to the reason that it considers bankruptcy cost very differently. It provides more flexibility in considering indirect bankruptcy cost whether or not i shows up in the pretax cost of debt. Another reason is that APV model uses cost of equity as a discounting factor which considers the tax benefit from a dollars debt value, usually based upon existing debt. The NPV model uses WACC as discount factor that estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future.

2. Since the company wants to finance the project with debt as well as equity the discount rate to be used will be WACC.

3. Discount rate to be used in APV analysis = 15%

Statement showing after tax operating cash flows

1 2
Operating cash flows before tax $2500000 $2500000
Less: tax 875000 875000
Add: tax savings on depreciation 1680000 1680000
3305000 3305000
PVF @15%` 0.870 0.756
P.V. 2875350 2498580

4. Since APV is better than NPV thus in oeder to use APV as a discounting factor US manufacturing city should be financed by equity share capital.

Amount of Equity = $24M

Amount of debt = 0

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