Question: Sedona Electronics of Arizona exports 25,000 Disc Drive Controllers (DDCs) per year to China under an agreement that covers the period 2009-2013. In China the DDCs are sold for the RMB (Chinese currency) equivalent of $50 per unit. The total costs in the United States are direct manufacturing costs and shipping costs, which amount to $35 per unit. The Market for DDCs in China is stable, and Sedona holds the major portion of the market. In 2010, the Chinese government, adopting a policy of replacing imported DDCs with local products, invited Sedona to open an assembly plant in China. If Sedona makes the investment, it will operate the plant for five years and then sell the building and equipment to Chinese investors at net book value at the time of sale plus the current amount of any working capital. Sedona will be allowed to repatriate all net income and depreciation funds to the United States each year. Sedona's anticipated outlay in 2010 would be $1,500,000 (buildings and equipment $750,000 and working capital $750,000). Building and Equipment will be depreciated over five years on a straight-line basis (no salvage value). At the end of the fifth year, the $750,000 of working capital may also be repatriated to the United States. Locally assembled DDCs will be sold for the RMB equivalent of $50 each. Operating expenses per unit of DDC are as follows:
Materials purchased in China (dollar equivalent of RMB cost) $15
Components imported from U.S. parent $ 8
Variable costs per unit $23
The $8 transfer price per unit for components sold by Sedona to its Chinese subsidiary consists of $4 of direct costs incurred in the U.S. and $4 of pretax profit to Sedona. There are no other operating costs in either China or the U.S. In both China and the United States, corporate income tax rate is 40 percent. Sedona uses a 15 percent discount rate to evaluate all its investment projects. Assume the investment is made at the end of 2010, and all operating cash flows occur at the end of 2011 through 2015. The RMB/dollar exchange rate is expected to remain constant over the five year period.
Required: a. Do you recommend that Sedona make the investment?
b. Sedona learns that if it decides not to invest in China, a Japanese company will probably make an investment similar to that being considered by Sedona. The Japanese investment would be protected by the Chinese government against imports. How would this information affect your analysis and recommendation?
c. Assume the conditions of question (b). China reduces income tax charged to foreign firms from 40 percent to 20 percent in order to attract foreign investors. How would this information affect your analysis and recommendation?