Question

Firm DFG plans to open a foreign subsidiary through which to sell its manufactured goods in the European market. It must decide between locating the subsidiary in Country X or Country Z. If the subsidiary operates in Country X, Its gross receipts from sales will be subject to a 3 percent gross receipts tax. If the subsidiary operates in Country Z, Its net profits will be subject to a 42 percent income tax. However, Country Z's tax law has a special provision to attract foreign investors: No foreign subsidiary is subject to the income tax for the first three years of operations. DFG projects the following annual operating results for the two locations (in thousands of dollars). Use Appendix A and Appendix B. Country X Country Gross receipts from sales $110,000 $110,000 Coat of sales (60,000) (60,000) Operating expenses (22,000) (15,000) Net profit $ 28,000 $ 35,000 DFG projects that it will operate the foreign subsidiary for 10 years (years through 9) and that the terminal value of the operation at the end of this period will be the same regardless of location. Assume a 5 percent discount rate. a. Determine the NPV of Country X. b. Determine the NPV of Country Z. c. Which location maximizes the NPV of the foreign operation.

Answer 1

3,300 14,700 Sales Tax 110,000 x 3% = Tax on profit 35,000 x 42% = Computation of NPV (Country X) Particulars 0 1 Cash Outflows: Sales tax (3,300) (3,300) Cost of Sales (60,000) (60,000) Operating expenses (22,000) (22,000) Years 4 2 3 5 6 7 8 9 (3,300) (3,300) (3,300) (3,300) (60,000) (60,000) (60,000) (60,000) (22,000) (22,000) (22,000) (22,000) (3,300) (3,300) (3,300) (60,000) (60,000) (60,000) (22,000) (22,000) (22,000) (3,300) (60,000) (22,000) Cash Inflows Sales Receipts 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 Net Incremental Cash floy PV factor @ 5% (b) Present Value (axb) 24,700 0.952 23,524 24,700 0.90703 22,404 24,700 0.86384 21,337 24,700 0.82270 20,321 24,700 0.78353 19,353 24,700 0.74622 18,432 24,700 0.71068 17,554 24,700 0.67684 16,718 24,700 0.64461 15,922 24,700 0.61391 15,164 Net Present Value (NPV) 190,727 Years 0 1 2 3 4 5 6 7 8 9 Computation of NPV (Country Y) Particulars Cash Outflows: Tax on Profit Cost of Sales (60,000) Operating expenses (15,000) (60,000) (15,000) (14,700) (14,700) (14,700) (14,700) (14,700) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (15,000) (15,000) (15,000) (15,000) (15,000) (15,000) (14,700) (60,000) (15,000) (14,700) (60,000) (15,000) Cash Inflows Sales Receipts 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 110,000 Net Incremental Cash floy PV factor @ 5% (b) Present Value (axb) 35,000 0.952 33,333 35,000 0.90703 31,746 35,000 0.86384 30,234 20,300 0.82270 16,701 20,300 0.78353 15,906 20,300 0.74622 15,148 20,300 0.71068 14,427 20,300 0.67684 13,740 20,300 0.64461 13,086 20,300 0.61391 12,462 Net Present Value (NPV) = 196,783 Solutions : a) b) NPV of country X NPV of country Y Location which maximizes the NPV 190,727 196,783 Country Y

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