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) Adjusted Present Value V/s Net Present Value

APV breaks the total value of the project into parts: one part is the value assuming no debt is used, and then you add on the extra value created from using debt in the capital structure.

While Calculating Net Present Value (NPV), if it is liveraged Capital Structue i.e. debt is used for Tax benefit, a factor WACC is used as discount factor.

All discounted-cash-flow methodologies involve forecasting future cash flows and then discounting them to their present value at a rate that reflects their riskiness. But the methodologies differ in the details of their execution, most particularly in how they account for the value created or destroyed by financial maneuvers, as opposed to operations. APV’s approach is to analyze financial maneuvers separately and then add their value to that of the business.

Idea APV unbundles components of value and analyzes each one separately. In contrast, WACC bundles all financing side effect into the discount rate.

In reality, WACC has never been that good at handling financial side effects. In its most common formulations, it addresses tax effects only—and not very convincingly, except for simple capital structures

2) WACC (assumed to be After Tax) = 11%

Cost of equity = 15%

PV of after tax Cash Flows : 11% (WACC)

PV of Dep Tax Shield : Dep is non cash accounting entry, for tax benefit. So, for calculating PV cash flows are lessons with dep rate and tax is applied at net income (after Dep).

PV of terminal Cash Flows : 15% (At cost of equity), as all cash flows are generated due to financinf wholy with equity.

3) APV is Calculated byu following steps :

Step 1 : Prepare performance forecast and base incremental cash flows for the business.

Step 2 : Discount base incremental cash flows and terminal value to present value

Step 3 : Evaluate financial side effects

Side effect : Dep Tax shied

Interest on debts tax shield

Step 4 : Add values for Step 2 and Step 3, to get an innitial APV.

4) Total Project Cost = 24 million

It should be financed as follows :

Debts : 7.5 million @6%

2.5 million @ 9%

Equity : 14 million

5) Dollar Interest Rate = 9%

Host city Subsidy rate = 7.5%

Subsidy rate = (9-7.5) = 1.5% interest subsidy

Loan Amount = 7.5 million

Subsidy = (7.5*1.5%)*5

= 0.56 million

Less: Tax expense @ 25% = 0.14 million

Net benefit = 0.42 million

6) PV for Interest :-

  

CC = (0.43875/10)

= 4.39%

Capital Rate of Int Interest 7.5 0.06 0.45 2.5 0.09 0.225 10 0.675 Less Tax Benefit @ 35% 0.23625 Net Cost 0.43875

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