For each of the first five years, 60 percent of the total profits will be distri

Question

For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.

Gibson's average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibson

Year Total Profits from Joint Venture (in BRL) 1 40 million 2 60 million 3 70 million 4 90 million 5 120 million

Explanation / Answer

Answer:

Answer: Cost of capital

Note:

                             CF1   CF2      CF3

cost of capital= ---------+--------+----------+-----

    (NPV)               (1+k)    1+k)^2   (1+k)^3

2.Assumptions:

1. Since JV is not the subsidiary of company. The cost of debt has to be taken @5.4% which is Cost of debt after tax.

2. Net Profits recd. In USA is taxed at 7% and effect of debt and equity has been considered before that.

3. Expected Cash Flow for company is Net profits after 7% deduction and No further deduction of 10% tax as this has alredy been accounted in cost of Debt.

Note:

Capital Structure: 70% Debt and 30% equity.

Debt= USD 5.6 million Equity= USD 2.4 million

Required rate of return= 2 to 5 % points + cost of capital

US tax rate: 10%

Average Cost of Debt: 6% before taxes

Cost of debt after tax= 6*(1-10%)= 5.4%

Average Cost of Equity: 9%

A. Calculation of Share in Profits Year Total Profits from the Joint Venture (in million BRL) another's Share (60% of total profits for first 5 years) company's Share (40% of the total profits in first 5 years) 1 40 24 16 2 60 36 24 3 70 42 28 4 90 54 36 5 120 72 48 B. Calculation of a Cash Flows for company under different scenario B(I) Cash Flow in Present Scenario Year company's Share (40% of the total profits in first 5 years) Post Tax (10%) Profits in BRL Repatriable amount in million USD    1BRL=USD 0.442831 Cost of Debt Servicing Cash Flow after Debt servicing Net cash flow after 7% deduction in USA (USD Million) 1 16 14.4 6.38 0.34 6.04 5.62 2 24 21.6 9.57 0.69 8.87 8.25 3 28 25.2 11.16 1.07 10.09 9.38 4 36 32.4 14.35 1.47 12.88 11.98 5 48 43.2 19.13 1.89 17.24 16.03 B(II) Expected Net Cash Flow in Scenario (I) & (II) Future Scenario (I) Year company's Share (40% of the total profits in first 5 years) Post Tax Profits in BRL, tax @30% Repatriable amount in million USD    1BRL=USD 0.442831 Cost of Debt Servicing Cash Flow after Debt servicing Net Cash Flow, No 7% deduction in USD 1 16 11.2 4.96 0.34 4.62 4.62 2 24 16.8 7.44 0.69 6.75 6.75 3 28 19.6 8.68 1.07 7.61 7.61 4 36 25.2 11.16 1.47 9.69 9.69 5 48 33.6 14.88 1.89 12.99 12.99 Future Scenario (II) Year company's Share (40% of the total profits in first 5 years) Post tax Profits, tax @10% Profit after Additional tax of 10% for Foreign company Repatriable amount in million USD    1BRL=USD 0.442831 Cost of Debt Servicing Cash Flow after Debt servicing Net cash flow after 7% deduction in USA (USD Million) 1 16 14.4 12.96 5.74 0.34 5.40 5.02 2 24 21.6 19.44 8.61 0.69 7.92 7.36 3 28 25.2 22.68 10.04 1.07 8.97 8.35 4 36 32.4 29.16 12.91 1.47 11.44 10.64 5 48 43.2 38.88 17.22 1.89 15.32 14.25 B(IV) Summary of nert cash flows in each scenario Net Cash Flow (in miilion) BRL Year Present scene Scene 1 Scene 2 1 5.62 4.62 5.02 2 8.25 6.75 7.36 3 9.38 7.61 8.35 4 11.98 9.69 10.64 5 16.03 12.99 14.25 B(III) Expected net cash flow for the project each year and probability distribution Year Case Net Cash Flow (NCF) Probability (P) NCF* P (NCF-ENCF)^2 (NCF-ENCF)^2 *P Varience/ (1+K)^2t 1 Present 5.62 0.6 3.37 3.72 2.23 Scene (I) 4.62 0.2 0.92 19.15 3.83 Scene (II) 5.02 0.2 1.00 18.45 3.69 Expected Cash Flow= 5.30 Variance1= 9.75 8.63 2 Present 8.25 0.6 4.95 7.96 4.78 Scene (I) 6.75 0.2 1.35 41.26 8.25 Scene (II) 7.36 0.2 1.47 39.70 7.94 Expected Cash Flow= 7.77 Variance2= 20.97 12.86 3 Present 9.38 0.6 5.63 10.18 6.11 Scene (I) 7.61 0.2 1.52 53.28 10.66 Scene (II) 8.35 0.2 1.67 51.15 10.23 Expected Cash Flow= 8.82 Variance3= 27.00 12.97 4 Present 11.98 0.6 7.19 16.53 9.92 Scene (I) 9.69 0.2 1.94 86.76 17.35 Scene (II) 10.64 0.2 2.13 83.24 16.65 Expected Cash Flow= 11.25 Variance4= 43.92 16.52 5 Present 16.03 0.6 9.62 29.67 17.80 Scene (I) 12.99 0.2 2.60 155.45 31.09 Scene (II) 14.25 0.2 2.85 149.20 29.84 Expected Cash Flow= 15.06 Variance5= 78.73 23.19 total 74.17 SD for project 8.61 B(III) Calculation of Required rate of return 13 Year Expected value of cash Flow, in million USD Present value of expected value of cash Flow 0 -8 -8 1 5.30 4.69 2 7.77 6.09 3 8.82 6.11 4 11.25 6.90 5 15.06 8.18 Expected net present value= 23.97 B(v) Probability Distribution Z Value Expected NPV neg 3 SD -1.87 neg 2 SD 6.75 neg 1 SD 15.36 0 23.97 1 SD 32.58 2 SD 41.19 3 SD 49.81

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