An Italian company is considering expanding the sales of its cappuccino machines to the U.S. market. As a result, the idea of setting up a manufacturing facility in the U.S. should be explored. The company estimates the initial demand in the 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 interest only loan of $7.5 million at 6% per annum (note: principal will be paid back in a lump sum at the end of year 5).
The U.S. IRS will allow the company to straight-line depreciate 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%.
1) Calculate the amount of funds that will be freed up by the new project.
2) Assume the preliminary estimate of the 5-year project's APV is -€1,000,000 (negative €1,000,000). Which does not included 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.
3) 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.