WILL IT BE WORTHWHILE TO VENTURE?

WILL IT BE WORTHWHILE TO VENTURE? Case Discussion

Objectives • Understand covered interest arbitrage and interest rate parity relationships. • Evaluate international capital budgeting proposals using “home currency” and “foreign currency” approaches.

Background Information • Murray Technologies is considering the feasibility of starting a joint venture in India for production of circuit boards. • Mike Cooper and Brad Johnson returning back to USA after checking out details. • Must report back to Ron Howard, Murray’s CEO, whether or not to go ahead with the deal.

Question 1: • What did Brad mean when he said that, based on covered interest arbitrage, it made no difference whether Murray Technologies raised the capital needed for the joint venture in India or in the USA? • Do you agree? Please explain.

Answer 1 • Brad was trying to tell Mike that in most developed countries, interest rate differences are offset by equal and opposite exchange rate differences • i.e. the forward exchange rate of the country with the lower interest rate will go up. • This means that the US$/Indian Rupee exchange rate would most likely strengthen and offset any interest cost advantage gained by the borrowing in the USA.

Answer 1 (continued) • The “covered interest arbitrage” argument states that if such a relationship between interest rates and exchange rates did not exist investors would be able to make risk-less profits. • Note: This implies that the Implied Forward Rate = Spot Rate*[(1+Inf.RateIndia) /(1+Inf.RateUS)] = Rs 50*(1.05/(1.02)] = Rs 51

Question 2: • Based on the differential inflation rate projections, what are the expected end of year exchange rates between the US$ and the Indian rupee for the next seven years?

Answer 2 Forward Rate t+1 = Spot Ratet*[1 + (Inflation rate difference t+1)] Forward Rate 1 = Rs 50*(1.02) = Rs 51 Forward Rate 2 = Rs 51*(1.03) = Rs 52.53

Question 3 • Based on the “home currency” approach what should Mike recommend?

Answer 3 • See Spreadsheet Solutions for details (click here) • Initial Outlay 1$ = 50 Rupees • Cost of Plant $ 2,800,000= Rs. 140,000,000 • NWC $ 600,000=Rs. 30,000,000 • Murray Tech's share 50%= Rs.85,000,000

Answer 3 (Cont.) • Annual Operating Cash Flows for years 1-7 • Net Cash Flow = (Revenue – Cost – Depreciation – Taxes) + Depreciation • Note: Depreciation = Rs 140,000,000/10 = Rs 14,000,000

Answer 3 (Cont.) • Terminal Year Cash Flow at n=7 • Selling Price of Plant = (.5)*130% of Net Book Value • Net Book Value = Rs 140,000,000 – 0.7*Rs 140,000,000 = Rs 42,000,000 • Selling Price = 0.5*1.3*Rs 42,000,000 = Rs 27,300,000 • Reimbursement of Murray’s share of Net Working Capital = Rs 30,000,000*.5 =Rs 15,000,000

Answer 3 (Cont.) • Total Terminal Year Cash Flow = Rs 27,300,000 + Rs 15,000,000 = Rs 42,300,000 • NPV at 15% = $787,481.54 • IRR = 27.9% • Note: These calculations have included the $3 per unit pre-tax profit made by Murray on the components imported by the joint venture from the USA. • Recommendation: Accept the project

Question 4 • Does the decision change if the “foreign currency” approach is used for the analysis? • Please explain with the help of adequate calculations.

Answer 4 • The decision should not change under the foreign currency approach. • See spreadsheet for details (click here)

Question 5: • As Mike went over the numbers once again, he realized that he had made a major error. • One of the machines, which were to be shipped over to India as part of Murray Technologies initial investment, had been accounted for at its book value of $500,000, even though it had an estimated market value of $700,000. • The machine could be depreciated on a straight-line basis over 7 years. • What effect would this error have on Mike’s analysis and recommendation?

Answer 5 • The cost to Murray would have to be increased by $200,000, since that is the opportunity cost associated with the machine. • The annual cash flows would also be affected by the loss of tax shields on the depreciation write-off, i.e (($200,000/7)*.4).

Question 6 • As Mike was inquiring about the tax provisions in India, he was told that there was a high probability that the Indian government would offer a reduced tax rate (20%) to foreign investors who used some indigenous raw materials and employed Indians. • If this does happen, how would the analysis be affected?

Answer 6 • The annual cash flows would increase and would make the joint venture more attractive.

Question 7: • How would Mike’s analysis and recommendation change if Murray Technologies intends to use this joint venture as a stepping-stone to maintain a permanent position in India and therefore reinvests its earnings in India?

Answer 7 • If Murray decides to reinvest its earnings in India, Mike would have to consider the political risk, long-term exposure to exchange rate fluctuations, and the translation exposure that would be entailed due to the need for reporting Indian returns in US$. • Furthermore, the proportion of earnings that are reinvested in India would not need to be converted into US$ at the forward exchange rates.

Answer 7 (Cont.) • Since the dollar is expected to strengthen over time, by leaving the money in India, the rate of return earned would be higher making the joint venture more attractive.

Question 8 • Besides exchange rate fluctuations, what other risk factors would Mike have to take into consideration before making his recommendation?

Answer 8 Besides exchange rate risk, political risk, economic risk, market risk, and cultural differences must be taken into consideration

Question 9 • What are the different ways in which Murray’s share of the cash flows from the joint venture can be remitted to the USA?

Answer 9 • Dividends, • Management fees for central services, • royalties on the use of trade names, and • patents are some methods by which Murray’s cash flows can be remitted to the USA.

Question 10 • Let’s assume that Mike was unable to get the Indian government to give him a firm commitment that cash flows earned by Murray Technologies could be freely remitted to the USA. • Imports could be paid for immediately but all other cash remittances would be blocked until the end of the fourth year. Funds invested in India could earn a tax-free rate of 4% per year. • What effect would this event have on the analysis and recommendation?

Answer 10 • See Spreadsheet Solutions for details (click here) • The NPV of the joint venture would be lower because the dollar is expected to appreciate at a faster rate (4% - 11.7%) during the first four years, than the 4% rate of return that could be earned in India until the end of year 4. • The remittances from years 4-6 would bring in fewer dollars than if they could be converted each year.

Answer 10 (Cont.) • For example: At the end of year 1 the estimated forward rate = $51 • At the end of year 4 the estimated forward rate = $56.82 • % appreciation in the dollar = 56.82/51 = 11.41% • The NPV is still positive and the recommendation would still be to go ahead with the joint venture.

WILL IT BE WORTHWHILE TO VENTURE?