Question

• Martin, Inc., is considering the development of a subsidiary in Sydney, Australia that would manufacture and sell high quality guitars on the local Australian Market. • As one of Martin’s financial managers, you have asked the finance, marketing and manufacturing departments to provide you with all of the relevant input so you can perform a capital budgeting analysis to determine whether to undertake this project or not. • In addition, a contingent of Martin executives have met with Australian government officials in Sydney to discuss the proposed subsidiary. • The project would end in 5 years. All of the relevant information that you need to perform this capital budgeting analysis follows here. • Initial investment: A$12,500,000 million (A$ = Australian dollars) • Price and consumer demand: Year 1 and 2: 20,000 units @ A$650/unit Year 3: 30,000 units @ A$760/unit Year 4: 40,000 units @ A$850/unit Year 5: 40,000 units @ A$880/unit • Costs Variable costs: Years 1 & 2 A$370/unit, Year 3 A$445/unit, Years 4 and 5 A$600/unit Fixed costs: A$2,000,000 per year ( A$1,000,000 lease and A$1,000,000 other fixed expense) • Depreciation A$1,000,000 per year • Tax laws: 30% income tax • Remitted funds: 15% withholding tax on remitted funds • Exchange rates: Spot exchange rate of $US 0.65 for Australian dollar • Salvage values: A$6 million • Required rate of return: 18% Given all of the preceding information, please create an Excel spread sheet that shows the year by year amounts that you have taken into consideration in your capital budget analysis and decide whether or not you will undertake this project.

Answer 1

Whether to undertake the project: the decision will be based on net present value of cash flows where

Net Present value = Present value of cash inflows - present value of cash outflows

Present value of cash inflows = Year-on-year cash flows discounted at required rate of return

Present value of cash outflows = initial cash outlay

Free cash flow calculations

	1	2	3	4	5
Price/unit	650	650	760	850	880
Less: Variable cost per unit	370	370	445	600	600
Contribution per unit	280	280	315	250	280
Demand (units)	20000	20000	30000	40000	40000
Contribution	5600000	5600000	9450000	10000000	11200000
less : fixed cost	2000000	2000000	2000000	2000000	2000000
less : depreciation	1000000	1000000	1000000	1000000	1000000
Profit before tax	2600000	2600000	6450000	7000000	8200000
Less: tax @30%	780000	780000	1935000	2100000	2460000
Profit after tax	1820000	1820000	4515000	4900000	5740000
Add: depreciation	1000000	1000000	1000000	1000000	1000000
Free Cash Flow	2820000	2820000	5515000	5900000	6740000
Add: salvage value					6000000
Amount available to remitt	2820000	2820000	5515000	5900000	12740000
Less: Withholding tax on remittance @ 15%	423000	423000	827250	885000	1911000
Amount to be remitted	2397000	2397000	4687750	5015000	10829000
Disounting factor @ 18%	0.85	0.72	0.61	0.52	0.44
Discounted cash flow	2031356	1721488	2853109	2586681	4733456
Present value of cash inflows A$	13926090.30
Exchange rate	0.65
Present value of cash inflows USD	9051958.69

Present value of initial cash outflow = A$ 12500000

Present value of initial cash outflow = 12500000 * .65 = 8125000

Net present value = Present value of cash inflows - present value of cash outflows

= 9051958.69 - 8125000 = 926958.69

Because present value at required rate of return of 18% is positive you will undertake this project.

Note 1 - Excel Calculations

В C E F 4. 1 2 5 2 Price/unit 650 760 650 850 880 Less: Variable cost per unit 3 370 370 445 600 600 4 Contribution per unit 5 Demand (units) 6 Contribution 315 280 280 250 280 20000 20000 30000 40000 40000 5600000 5600000 9450000 10000000 11200000 less fixed cost 7 2000000 2000000 2000000 2000000 2000000 less depreciation 9 Profit before tax 10 Less: tax @30 % 11 Profit ofter tax 12 Add: depreciation 1000000 1000000 1000000 1000000 1000000 2600000 2600000 6450000 7000000 8200000 780000 780000 1935000 2100000 2460000 1820000 1820000 4515000 4900000 5740000 1000000 1000000 1000000 1000000 1000000 13 14 Free Cash Flow 15 Add: salvage value 16 Amount available to remitt 17 Less: Withholding tax on remittance @ 15% 18 Amount to be remitted 2820000 5900000 6740000 2820000 5515000 6000000 2820000 5900000 2820000 5515000 12740000 423000 423000 827250 885000 1911000 2397000 2397000 4687750 5015000 10829000 19 20 Disounting factor @ 18% 21 Discounted cash flow 0.72 0.85 0.61 0.52 0.44 1721488 2031356 2853109 2586681 4733456 22 23 Present value of cash inflows AS 24 Exchange rate 25 Present value of cash inflows USD 13926090.30 0.65 9051958.69

Note 2 - Excel formulas

В C E F 4 1 2. 850 2 Price/unit: 650 650 760 880 Less: Variable cost per unit 370 370 600 445 600 4 Contribution per unit 5 Demand (units) 6 Contribution %3В2-ВЗ -C2-C3 D2-D3 -E2-E3 F2-F3 20000 40000 -F5 *F4 30000 40000 20000 -D5*D4 -E5*E4 -B5*B4 -C5 *C4 2000000 2000000 less fixed cost 2000000 2000000 2000000 7 less depreciation 9 Profit before tox 10 Less: tax @30 % 1000000 1000000 =F6-F7-F8 1000000 1000000 1000000 |ЕB6-B7-B8 -89*0.3 3С6-С7-С8 -D6-D7-D8 -E6-E7-EB -D9*0.3 -E9*0.3 =F9*0.3 -F9-F10 C9*0.3 11 Profit ofter tax 12 Add: depreciation |ЕC9-C10 -E9-E10 B9-B10 D9-D10 ED8 =F8 =B8 -C8 -E8 13 -C11+C12 -D11 + D12 -E11 + E12 14 Free Cash Flow -B11+ B12 F11+F12 15 Add: salvage value 16 Amount available to remitt 17 Less: Withholding tax on remittance 18 Amount to be remitted 6000000 -SUM(B14:815) -SUM(C14 C15) C16*15 % -C16-C17 -SUM(D14:D15) -SUM(E14: E15) -SUM(F14:F15) 15%B16*15% D16*15% E16*15% =F16*15 % -E16-E17 -B16-B17 D16-D17 F16-F17 19 20 Disounting factor @ 18% 21 Discounted cash flow -1/ (1+18 % ) A5 -F18 F20 -1/ (1+18 % ) B18 B20 -1/ (1+18 % )A3 -1/ (1+18 % ) 4 -E18*E20 1/(1+18% ) A2 -C18*C20 -D18*D20 22 -SUM(B21:F21) 0.65 23 Present value of cash inflows AS 24 Exchange rate 25 Present value of cash inflows USD -B23 *B24

Note 3 Assumption

Asset Cost = 12500000

Total depreciation in 5 years = 5000000

Salvage value = 6000000

Value unaccounted for = 12500000-5000000-6000000 = 1500000

We have assumed that this 1500000 has no tax implications in the 5th year