Nestle corp. currently has no existing business in new zealand but is

Nestle Corp. currently has no existing business in New Zealand but is considering establishing a subsidiary there. The following information has been gathered to assess this project:

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The initial investment required is $50 million in New Zealand dollars (NZ$). Given the

existing spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The yearly repayment on this loan is to NZ$ 2,800,000.  The loan principal is to be paid in 10 years.

 

The project will be terminated at the end of Year 3, when the subsidiary will be sold.

 

The price, demand, and variable cost of the product in New Zealand are as follows:

Year, Price, Demand, and Variable Cost

Year     Price                Demand                       Variable Cost

1          NZ$500           40,000 units                NZ$30

2          NZ$511            50,000 units                NZ$35

3          NZ$530           60,000 units               NZ$40

               

The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.

 

The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at the end of Year 2, and $.56 at the end of Year 3.

 

The New Zealand government will impose an income tax of 30 percent on income. In

addition, it will impose a withholding tax of 10 percent on earnings remitted by the

subsidiary.

 

All cash flows received by the subsidiary are to be sent to the parent at the end of each year.

 

The plant and equipment are depreciated over 10 years using the straight-line depreciation method. Since the plant and equipment are initially valued at NZ$50 million, the annual depreciation expense is NZ$5 million.

 

In three years, the subsidiary is to be sold.. Nestle expects to receive NZ$52 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.

 

. Nestle plans to let the acquiring firm assume the existing New Zealand loan

 

 

•Nestle requires a 20 percent rate of return on this project.

 

Questions & Discussions

 

a.       Determine the net present value of this project. Should Nestle accept this project?

 

b. Assume that Nestle is also considering an alternative financing arrangement, in which the parent would invest an additional NZ$20 million  to cover the working capital requirements so that the subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of the subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this alternative financing arrangement more feasible for the parent than the original proposal?  Explain.

 

C. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent invests more of its own funds to cover the working capital? Explain.

 

 

D. Assume Nestle used the original financing proposal and that funds to be remitted are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the end of Year 3. How is the project’s NPV affected?

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