Finance Sources of Foreign Direct Investment - Coursework Example

 Finance Sources of Foreign Direct Investment Part 1. Thunderbolt Plc can proceed with the proposal to establish a subsidiary in Utopia based on the following criteria: 1. Weighted Average Cost of Capital: The arrived WACC is 4% that is based on the 31 July, 2010 Statement of Financial Position of Thunderbolt. (See attached calculations). The WACC Is the rate used in looking for the NPV of the proposal. 2. Market Rate of Return for investment is done using the WACC and is also 4% this is also parallel with the target inflation rate of Utopia in foreseeable future. 3. Tax depreciation has been calculated using the Utopian government policy wherein depreciation in plant and equipment like the Thunderbolt project is allowed a 40% depreciation rate for the first year of operation, and subsequently on a reducing balance basis at 25 per cent per annum. Depreciation is carried on as an expense in the income statement and reported for the 10 year life period. 4. Inflation adjustments and the foreign exchange translation using the temporal method show that as inflation rate decreases, the exchange rate is affected. 5. A double taxation is charged to Thunderbolt, that is: Utopia charges 25% income tax rate to foreign subsidiaries and at the same time a 5% withholding tax for earnings of foreign subsidiaries is deducted. For the first 3 years, Utopia charges 10% for the first three years for start-up corporation, then goes up to its regular tax rate thereafter. 6. The Discounted pay back and NPV arrived at a positive value showing that the project is acceptable. With a discount rate of 4% and a span of 10 years, the projected cash flows are worth $3,809,770,707.88 today which is greater than the initial investment of the company. 7. This appraisal has considered the discounting method to get the payback period, accounting rate of return, net present value and internal rate of return. The payback period is the time taken to recover the cost of investment. In our case, the payback period is 2.4 years. However, the limitations seen in the payback period is that it does not consider the benefits that occur after the payback period and does not regard the time value of money. (“Payback Period”, n.d.) The accounting rate of return for this project is found to be 0.16% after dividing the average profit by the average investment. The profit number is the profit from the investment while the average investment is the book value of the investment. The limitations of this method is like the payback period that does not consider the non-cash items and time value of money, and risk, thus decision using this as basis is subject to flaws. (ARR, n.d.) The net present value is found to be positive that shows future cash flows is more than the initial investment cost. The internal rate of return is the discount rate of investment that will give its net present value of zero. The discount rate used in the assessment is the WACC that is 4% which gave a value of more than zero. The second type of appraisal is the non-discounting methods (NDM) that does not consider the time value of money. The NDM takes account of the “financial return from an investment comes in a stream over the years” (“Investment appraisal, n.d.) Based on the above contexts, the NPV and IRR have established their superiority as methods of appraisal, as it takes into consideration the profits over the whole life of the project and the timing of the return. Thus, the discounting method of appraisal is used in the appraisal. 8. Recommendation a. Setting up of subsidiary in Utopia will cost a total of $828 million – the cost of the factory plus the cost of closure of factory in UK. The cost of closure is partially offset by selling the factory, plant and equipment in Midlands. In appraising the investment proposal using the NPV method, the net benefit of the company from the investment is more than the initial investment, which means, it is an acceptable proposition. Calculation of the NPV is attached. Cost of setting up a subsidiary £400,000,000 US$ Additional expense for factory closure in UK 22,000,000 Less: Cost offset by selling of factory, plant, etc. 8,000,000 Total additional cost 14,000,000 Total set up cost £414,000,000 $828,000,000 b. The double taxation; that is 25% retained in Utopia and 5% withheld for remittance to country of origin is almost parallel with UK corporate tax of 30%, and therefore is not an added benefit. c. Tax depreciation policy of Utopia is beneficial to the company rather than the straight line depreciation because the allowable tax credits can be used by the company for operation purposes or invested in other endeavor. d. Surplus funds are seen from the yearly cash flow statement that shows operations in Utopia can support itself without resorting to additional capital infusion. The first year of operation, 2011 is expected to have a low indication of profitability and required an infusion of capital at the beginning of the year 2012. However, for the rest of the years from 2012 to 2020, projected stream of cash flows can support its operations. A surplus fund at the end of the year will be available for remittance to the parent company that is required. Cash flows are more important to investors as this is based on numbers that reflects the result of operations. 1- B. Motives for foreign direct investments by a multinational company Modern technology, communication and transportation have spurred economic movement towards global outsourcing and foreign direct investments of multinational companies. For many years now, the benefits of external outsourcing and international production capabilities have been recognized by multinationals. For instance, multinationals continue to look for ways to improve their efficiency, productivity and competitiveness in the market. They look for cost saving measures that can be provided outside its own boundaries. In many instances, multinationals source parts of their assembly from low-cost suppliers abroad, and for some reasons, transfer their production process to a new location offshore. For these grounds, many multinationals have established subsidiaries in North America, Europe, Asia Pacific regions and in other regions, away from their headquarters or parent company. Multinationals like Thunderbolt Plc are motivated to go into foreign direct investments in order to continue generating future growth. Citing the study done by UNESCO, chapter 3, “Motivations for FDI” said that there is an upward trend in FDI as multinationals find international sourcing, procurement and production more advantageous to one another. Specifically, these benefits are outlined below Source: United Nations Economic and Social Commission for Asia, n.d. In our case, Thunderbolt has established subsidiaries in many foreign countries known as the emerging markets because of its corporate policy to generate future growth. The benefits that Thunderbolt will most likely have in establishing its subsidiary in Utopia are the special privileges like tax privileges, fiscal incentives and employment laws that are more favorable to foreign businesses as compared to other emerging markets in Asia. Utopia has a well-educated and highly skilled work force and labor employment will not be a problem to Thunderbolt. Others are its government policy geared towards economic growth, its relative peace and order, its rich reserves of mineral resources and technology. In terms of operating costs, Thunderbolt will be more efficient in reducing inventory costs, delivery time and will be maximizing its capacity and capabilities. 1 - C. Possible barriers to foreign direct investment and explain what impact these may have on Thunderbolt’s strategy of expansion. Before entering into outsourcing into a new market, there are certain conditions that have to be addressed by a company like barriers to entry. Some of these barriers to entry have been identified in Michael Porter’s model for industry analysis (“Porters…” n.d.). These are “absolute cost advantages, proprietary learning curve, access to inputs, government policy, economies of scale, capital requirements, brand identity, switching costs, access to distribution, expected retaliation and proprietary products” From these factors, I consider government policy and capital requirement to be the ones having a direct impact on Thunderbolt’s strategy of expansion. Government policy plays an important role in FDI because of its ability to exercise monetary and fiscal policies in the country. Monetary policies are those concerning expansion or contraction of monetary supply in the country to check inflation. Inflation rates affect investment as high interest rates contracts money supply while expansion policy reduces interest rates, in that both policies are related to investments of FDI. (“Inflation & Monetary Policy”, n.d.) In our situation, inflation rate in UK remains stable at 2% while Utopia has 10% inflation rate which is expected to remain stable at 4% in the succeeding years. A high inflation rate means that capital becomes more expensive and it reduces the real value of money over time. 1 – D. Comment in detail on Mr. Kent’s desire to raise the finance or part of it in Utopia and the possible impact such a decision might have on the investment appraisal. Comparing the merits of getting a loan from UK and that from Utopia, it is seen that a loan from Utopia is more desirable because of lower interest. In the calculation, it is assumed that Utopia uses the US dollar currency and applies the same base of interest. U.S. Fed rate is set at 0.25% and is used as comparison. UK has 0.5% base rate and therefore shows a difference of 0.25%. It is also assumed that the loan will receive same additional interest of 1.8% from both countries. Thus, getting the loan from Utopia is advantageous to the company. Comparison is shown in table below: UK loan Utopia loan Exchange rate $1= £1 Loan £400,000,000 $800,000,000 Base rate 0.5% 0.25% Additional bank interest 1.8% 1.8% Effective rate before tax 2.30% 2.05% Due to lack of data Assumptions used: Utopia uses US$ currency & base interest Part 2 Comparison of getting a loan in UK and in Germany UK Germany Loan 12,000,000 9,798,000,000 Base rate 0.50% 1.75% Additional interest 1.80% 1.80% Before tax rate 2.30% 3.55% After tax rate 2.2471% 3.243% Cost of interest of loan for one year 270,000.00 335,481.07 In 2009, base rate of interest in UK is 0.50% while it is 1.75% in Germany. The exchange rate of euro to GBP is 0.81650 and the equivalent of £12million loan in UK is €9,798,000 in Germany. Both countries provide an additional interest of 1.80%. Effective tax rate can be measured both in terms of before tax or after tax rate. The definition of “cost of debt” suggests that the after-tax cost is seen to be more efficient measure because interest expense is deductible. (“What does…”) In this measure, securing a loan in Germany is not recommended because it produces a higher cost of interest to be paid by Thunderbolt, Plc Part 3. Calculations CALCULATIONS FOR WACC           WACC can be expressed as WACC = (1-L)re + L(1-T)rd     where L is the proportion of debt financing to total investment value,     re is the required return for equity,     T is the corporate rate tax rate on income from the project     rd is the required return for debt     WACC = (1-L)*re + L(1-T) * rd     L = proportion of debt financing to total investment value     re = required return for equity     T = corporate tax rate     L = 961,875,000   Total investment value 800,000,000   Debt financing 1.20234375   L= 2%   rd = required return for debt 18%   re 30%   T (1-L ) * re + L (1-T) * rd    1-1.202) * 0.18 + 1.201 (1-0.30) * 0.02 (   WACC = 0.39   2. CALCULATION FOR DISCOUNTED PAY BACK AND PRESENT VALUE         $ PV at 4%   Cost of factory $ (800,000,000.00)     market research $ (780,000.00)     2011 $ - $0.96 $ - 2012 $ 330,525,000.00 $0.92 $ 305,588,871.90 2013 $ 436,893,750.00 $0.89 $ 388,396,796.18 2014 $ 431,010,938.00 $0.85 $ 368,429,873.85 2015 $ 512,258,153.00 $0.82 $ 421,038,806.92 2016 $ 594,193,652.00 $0.79 $ 469,600,156.08 2017 $ 648,645,239.00 $0.76 $ 492,917,192.73 2018 $ 647,483,929.00 $0.73 $ 473,110,032.08 2019 $ 646,612,947.00 $0.70 $ 454,301,850.59 2020 $ 645,959,713.00 $0.68 $ 436,387,127.55       $ 3,809,770,707.88 The sum of all PV is the NPV       if the sum is greater than 0       invest in the project       CALCULATION OF TAX DEPRECIATION   Undepreciated     Cost, year end  Plant & equipment 580,000,000.00   40% 232,000,000.00 348,000,000.00 25% 87,000,000.00 261,000,000.00 25% 65,250,000.00 195,750,000.00 25% 48,937,500.00 146,812,500.00 25% 36,703,125.00 110,109,375.00 252% 27,527,343.75 82,582,031.25 25% 20,645,507.81 61,936,523.44 25% 15,484,130.86 46,452,392.58 25% 11,613,098.15 34,839,294.43 25% 8,709,823.61 26,129,470.83 Salvage value 6,532,367.71 19,597,103.12       Straight line depreciation 580,000,000.00   4%, 10 years 23,200,000.00     232,000,000.00   10 years 348,000,000.00 348,000,000.00 Salvage value     Estimated selling value     if factory is closed after 270,000,000.00   10 years     Net return to owner 78,000,000.00   TRANSLATIONS FROM US$ TO £         TEMPORAL RATE METHOD   US$ FX rate POUND £       US2= L1       $ 800,000,000.00 $2.00 400,000,000.00 initial investment 2011   $ 324,000,000.00 $2.00 162,000,000.00 Total Cash flows 2012           2%       Inflation rate in UK 8%       Inflation rate in Utopia 2011 6%       Inflation rate in Utopia 2012 4%       Stabilized rate in Utopia         Difference of inflation rate 2%   324,000,000 US$ 1.98 = L1 163,636,363.64 COMPUTATION OF TAX PAYABLE UTOPIA UK     30% 2011 none $ 6,600,000.00 10% 2012 $ 29,475,000.00 none 10% 2013 $ 43,106,250.00   25% 2014 $ 140,824,218.75 $ 28,164,843.75 25% 2015 $ 173,118,164.25 $ 34,623,635.85 25% 2016 $ 204,838,623.05 $ 409,677,724.61 25% 2017 $ 226,128,967.29 $ 45,225,793.40 25% 2018 $ 227,096,725.46 $ 45,419,345.09 25% 2019 $ 227,822,544.10 $ 45,564,508.82 25% 2020 $ 228,366,908.00 $ 45,673,381.61 Note: 5% w/holding tax is Deducted from earnings of Foreign subsidiary REFERENCES “Payback Period”, n.d. Viewed 01 Sept. 2010 from http://www.12manage.com/methods_payback_period.html ARR Accounting Rate of Return n.d. London School of Business & Finance. Viewed 01 Sept. 2010 http://moneyterms.co.uk/arr/ “Euro base interest rates” (2010) Viewed 30 August, 2010 http://www.ecb.int/stats/monetary/rates/html/index.en.html “Inflation & Monetary Policy”, n.d. Economy Watch http://www.economywatch.com/inflation/economy/monetary-policy.html “Investment appraisals”.n. d. tutor2u. Viewed 01 Sept. 2010 http://tutor2u.net/business/presentations/accounts/investappraisaldiscounting/default.html “Motivations for FDI and the development of global value chains.” Chapter 3. United Nations Economic and Social Commission for Asia . Viewed 31 August 2010 from www.unescap.org/publications/detail.asp?id=1356 “Payback Period”, n.d. Viewed 01 Sept. 2010 from http://www.12manage.com/methods_payback_period.html “Porters’ Five Forces” n.d. Quick MBA Strategic Management. Viewed 30 August 2010 www.quickmba.com/strategy/porter.shtml UK Interest rates. (2010). Houseweb. Viewed 30 August, 2010 from http://www.houseweb.co.uk/house/market/irfig.html What Does Cost of Debt Mean? Definition. Viewed 30 August, 2010 from http://financial-dictionary.thefreedictionary.com/Cost+of+Debt Read More