Project  - Capital budgeting for a multinational project

Project: Analyze the capital budgeting decision that Spec Equipment US, Inc. (Spec US) faces relative to the proposed Kenya project described below (Spec Kenya). The attached file has all information that you need about the project.

1. Forecast expected cash flows for the Spec Kenya project.

2. Calculate the IRR for the project. (You do not need to determine the NPV of the project.)

3. Forecast expected net incremental cash flows for Spec US if they take the project.

4. Determine the WACC for Spec US.

5. Calculate the NPV of the project for Spec US.

6. Indicate whether Spec US should undertake the project, and explain briefly.

Submit a spreadsheet containing all cash flows for the Spec Kenya and for Spec US, and showing your calculations for IRR for Spec Kenya; and NPV and IRR for Spec US.

Spec Equipment US, Inc.: Kenya Project

Spec Equipment US, Inc. (referred to below as Spec US) manufactures a wide range of machinery for a diverse group of industries. Its average annual revenue for the last five years is $12.5 billion. It is currently considering establishing a subsidiary in Kenya. It has developed relationships with Kenyan firms in several industries and believes that it can increase its penetration of the African market with a local presence. It also hopes to benefit from expected expansion of economies in African states.

Spec US will own 75% of the Kenyan subsidiary (referred to below as "Spec Kenya") with the balance owned by local firms and nationals, all of which have interests coincident with Spec US. Except as specifically noted, all net cash flows are divided pro-rata among the owners.

Initial plant and equipment

Spec Kenya can purchase land for a manufacturing facility from the Kenyan government for KSh 700 million. Construction and equipment costs are $10 million and $70 million, respectively.

The entire cost of the land and half of the plant and equipment cost will be paid at the beginning of construction (time 0) and the other half at the end of the first year (time 1). Spec Kenya will begin operating the plant one year after the start of construction (so the first cash flows for Spec Kenya will be in period 2). Depreciation of equipment under Kenyan tax law will be straight-line over a 10-year life and construction costs depreciate straight-line over a 20-year life; both with no salvage value.

Working capital

Spec Kenya will maintain a cash balance equal to 5% of expected next year's sales, and inventory of 75 days of expected next year's sales. It will carry accounts receivable and accounts payable equal to 25% and 30% of the current year's sales, respectively.

Sales

Spec Kenya will operate the project for 11 years (i.e., operating period is time 2 through time 12). Expected sales in the first operating year are 630 units. Units sold increase 18% per year. The initial per unit sales price is KSh 3.9 million and price increases with Kenyan inflation, estimated at 5.0% per year.

Costs

Spec US provides components parts to Spec Kenya at $5850 per unit in the first year of operations. This price increase with US inflation, estimated to average 2% per year. Local materials and labor for Spec Kenya cost KSh 1.15 million per unit in the first year of operations and costs increase with Kenyan inflation.

Indirect costs are KSh 130.5 million in the first year and increase 7.5% per year. Variable costs of sales equal 9.5% of sales revenue. Semi-variable costs are 12% in the first year of sales and increase 3.5% per year. (That is, the amount of semi-variable costs increase year to year by 3.5%; the percentage does not increase from 12% to 15.5% etc.).

Fees

Spec Kenya will pay Spec US an overhead allocation and marketing fee (for marketing, management and accounting services provided to Spec Kenya by Spec US) equal to $2,340 per unit sold. This fee will increase annually with U.S. inflation.

Interest

Spec Kenya will borrow all funds necessary for working capital from local lenders at an interest rate of 13% per year. Interest is payable annually at year end and working capital loans will be rolled over and increased or decreased as required annually.

Spec Kenya invests undistributed excess funds at each year-end and earns interest at 13%, paid annually.

Taxes

Kenya

Spec Kenya pays corporate income taxes in Kenya at 37.5%. Kenya also imposes a withholding tax of 10% on distributions from projects in Kenya to foreign owners. That tax applies to dividends paid to Spec US and to the overhead allocation and license fees.

US

Spec US pays no additional US income tax on dividends from Spec Kenya (due to the direct foreign tax credit), but does pay US income tax (21%) on profit realized on component parts sold to Spec Kenya. That profit equals 10% of the revenue received for component part sales.

Spec US pays additional US tax of 11% on the overhead allocation and license fee received from Spec Kenya.

Dividends

The government of Kenya will not permit Spec Kenya to pay any dividends during its first five years of operations. As a result, all net cash flows in years 2-6 are reinvested as undistributed excess funds.

Beginning in year 7, Spec Kenya pays 75% of its earnings (i.e., net income, not net cash flow) as dividends, allocated pro-rata among its owners, i.e., 80% of that amount is paid to Spec US. All cash flows in excess of net income are invested as undistributed excess funds.

At the end of year 12, Spec Kenya will terminate the project, sell the assets for an expected net after tax cash flow of KSh 700 million, and distribute those funds together with all accumulated investment funds to the owners on a pro-rata basis.

Replacement of Spec US Exports

Production by Spec Kenya in Kenya replace exports Spec US would otherwise realize causing the after-tax cash flow of Spec US to decline as follows: year 2, $810 thousand; year 3, $650 thousand; year 4, $480 thousand; year 5, $450 thousand; and year 6, $300 thousand.

Spec US Capital Structure

Spec US present funding is as follows:

Equity: 80 million shares outstanding. Current stock price is $70.50 per share. The firm expects to pay dividends in the next year equal to $1.75 per share, and expects the company's growth rate over the next 25 years to be 11.5% per year.

Domestic debt of $1.75 billion with a before tax cost of 9%

Foreign currency denominated debt of $600 million with a before tax average cost of 12.5%.

New debt is expected to cost 10%.

Project Funding

Spec US will fund its investment in Spec Kenya using equity and new debt in the same proportion as its current capital structure.

Kenyan currency

Kenyan currency, the Kenyan shilling (KES) currently trades at KSh100.999 per U.S. dollar.