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CHAPTER 17 CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION This chapter focuses on three aspects of foreign investment analysis that are infrequently considered in evaluating domestic projects: the difference between project and parent cash flows; incorporating political risks such as expropriation and currency controls; and factoring in inflation and exchange rate changes in cash flow estimates. It also evaluates the various methods used to incorporate in the investment analysis the additional risks encountered overseas. These points are brought out in the process of working through the International Diesel Corporation Case. The ability to perform a capital budgeting analysis is one of the most valuable skills we can provide our students; this case is designed to make them aware of many of the intricacies involved in doing such an analysis. At the back of the chapter I have included a set of questions (2-13) that students should bear in mind while reading the case. Addressing these questions will help them to get more out of the case. I have found that a quick review of capital budgeting basics, given in the first section, is useful for most students. The key point made in Appendix 17A is that a firm's exposure to political risk is a function of government actions and the impact of those actions on the firm's cash flows. The corollary is that a firm can take actions, preferably before making an investment, to reduce its susceptibility to political risk. Thus, much of political risk is firm-specific rather than county-specific. I discuss general principles as well as specific tactics that MNCs can use to reduce their political risk exposure. A key point here is that a firm's political risk is not independent of the ways in which the firm is structured and financed. The chapter illustrate the application of these principles and tactics by showing how American Motors dealt with the risk it faced at its Jeep factory in Communist China and how Anaconda and Kennecott prepared for the risk of having their Chilean copper mines expropriated by the government. Although several cases are available to give students experience in applying to actual numbers the analytical techniques presented in this chapter, my favorite case remains "Ghana Fertilizers," in Raymond Vernon and Louis Wells, Manager in the International Economy (Third edition), Prentice-Hall. It forces students to calculate cash flows, to analyze various political and economic risks, and to think in terms of the firm's overall strategy. Although quite old, this case is a classic. SUGGESTED ANSWERS TO CHAPTER 17 QUESTIONS 1. A foreign project that is profitable when valued on its own will always be profitable from the parent firm's standpoint. True or false. Explain. ANSWER. There are many reasons why project cash flows can diverge from the incremental cash flows accruing to the parent. Therefore, the correct answer is false. 2. What are the principal cash outflows associated with the IDC-U.K. project? ANSWER. The principal cash outflows associated with the IDC-U.K. project are a) The initial investment outlay, consisting of the plant purchase, equipment expenditures, and working capital requirements b) Operating expenses c) Later additions to working capital as sales expand d) Taxes paid on its net income. 3. What are the principal cash inflows associated with the IDC-U.K. project? 8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 7TH ED. ANSWER. The principal cash inflows associated with the IDC-U.K. project include a) Cash inflows from sales in England and other EC countries b) The tax shield provided by depreciation and interest charges c) Interest subsidies d) The terminal value of its investment, net of any capital gains taxes owed upon liquidation. This figure includes recapture of working capital. 4. In what ways do parent and project cash flows differ on the IDC- U.K. project? Why? ANSWER. Parent and project cash flows differ on the IDC-U.K. project in several ways: a) Funds remitted to IDC-U.S. may lead to additional taxes paid to England or the United States. These are cash outflows from the view of IDC-U.S. but not IDC-U.K. b) IDC-U.S. owes tax to the U.S. Internal Revenue Service on gains associated with the sale for $5 million of equipment having a book value of zero. c) IDC-U.S. receives licensing and overhead allocation fees each year, for which it incurs no additional expenses. These fees are costs to IDC-U.K. d) IDC-U.S. also profits from exports to IDC-U.K. e) If sales of IDC-U.K. just substitute for exports from IDC-U.S., then IDC-U.K.'s profits are overstated by an amount equal to the incremental cash flow that IDC-U.S. would have earned on these lost exports. 5. Why are loan repayments by IDC-U.K. to Lloyds and NEB treated as a cash inflow to the parent company? ANSWER. Loan repayments by IDC-U.K. to Lloyds and NEB are treated as cash inflows to the parent because they reduce its outstanding consolidated debt burden and increase the value of its equity by an equivalent amount. Assuming that the parent would repay these loans regardless, then having IDC-U.K. borrow and repay funds is equivalent to IDC-U.S. borrowing the money, investing it in IDC- U.K., and then using IDC-U.K.'s higher cash flows (since it no longer has British loans to service) to repay IDC-U.S.'s debts. 6. How sensitive is the value of the project to the threat of currency controls and expropriation? How can the financing be structured to make the project less sensitive to these political risks? ANSWER. Figures in Exhibit 17.6 reveal that the value of IDC's English project is quite sensitive to the potential political risks of currency controls and expropriation. The project NPV does not turn positive until well after its fifth year of operation (assuming there are no lost sales). Should expropriation occur or exchange controls be imposed at some point during the first five years, the project is unlikely to ever be economically viable. In the face of these risks, the project is viable only if compensation is sufficiently great in the event of expropriation, or if unremitted funds can earn a return reflecting their opportunity cost to IDC-U.S., with eventual repatriation, in the event of exchange controls. The project can be made less sensitive to political risks by using pound financing. Pound cash flows from the project can be used to service these debts. By borrowing from British banks, IDC will also have fewer assets at risk in the event of expropriation. In addition, the impact of potential currency controls can be minimized by setting high initial transfer prices on the sale of components to IDC-U.K. by other units, by setting fees and royalties at a high initial level, and, to the extent possible, by investing parent funds as debt rather than equity. 7. What options does investment in the new British diesel plant provide to IDC-U.S.? How can these options be accounted for in the traditional capital budgeting analysis? 7 CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION ANSWER. Here are some of the option that IDC-U.S. will realize by investing in the British diesel plant: The plant's output can be raised or lowered depending on current and expected future demand conditions, currency movements and other relative cost changes; the plant can be expanded or shut down, temporarily or permanently, again depending on future cost and market conditions (e.g., the success or failure of Europe 1992). Moreover, IDC has an enhanced market position in the EEC that can be used to expand its product offerings in the future, depending on demand conditions as well as the output of IDC's R&D efforts. 8. Early results on the Lexus, Toyota's upscale car, showed it was taking the most business from customers changing from either BMW (15%), Mercedes (14%), Toyota (14%), General Motors' Cadillac (12%), and Ford's Lincoln (6%). With what in the auto business is considered a high percentage of sales coming from its own customers, how badly is Toyota hurting itself with the Lexus? ANSWER. Toyota appears to be hurting itself with Lexus. But, in fact, Lexus is doing exactly what Toyota intended: retaining customers, since Toyota determined that many of its customers who switched to Lexus were ready to "trade up" to a luxury car. Now Toyota's customers are trading up to a Lexus instead of a BMW or Mercedes. The key point is that the cannibalization is more apparent than real: If Toyota had not built the Lexus, it would have lost these customers anyway, but to another company. 9. Comment on the following statement that appeared in The Economist (August 20, 1988, p. 60): Those oil producers that have snapped up overseas refineries--Kuwait, Venezuela, Libya and, most recently, Saudi Arabia--can feed the flabbiest of them with dollar-a-barrel crude and make a profit.... The majority of OPEC's existing overseas refineries would be scrapped without its own cheap oil to feed them. Both Western European refineries fed by Libyan oil (in West Germany and Italy) and Kuwait's two overseas refineries (in Holland and Denmark) would almost certainly be idle without it. ANSWER. The statement that OPEC can make a profit from these refineries is incorrect, assuming the author is referring to true economic profit. On an integrated basis, profits on the refinery are more than offset by losses on sales of the crude oil at subsidized prices. In fact, the oil producers are cross-subsidizing their refineries. They would be better off without the refineries and selling their oil on the open market. As noted in the chapter, investments should be evaluated taking into account the true opportunity costs of all the assets used. 10. In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian state-owned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on the price GE paid). a. What might account for GE's decision to spend so much money to acquire such a dilapidated, inefficient manufacturer? ANSWER. Eastern Europe has the potential to be both a large market for Western goods and a low-cost manufacturing platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years experience in "they pretend to pay us and we pretend to work" can produce at the level and quality necessary to be competitive with their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern European market. It also is learning what it takes to install modern Western management methods in a former communist country and to use Hungary as a low-cost backdoor to Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak global presence. GE's presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically it has dominated the U.S. market. Then came a highly successful raid on GE's U.S. fortress by Philips, which is the world's largest light bulb producer. GE decided to fight back by storming Philip's European base. But GE was unable to acquire a controlling interest in any Western European firm and building a new plant would have 8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 7TH ED. cost at least $300 million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European market; (b) introducing new technologies and higher-priced products to Tungsram; and (c) a low-cost export platform. b. A Hungarian light bulb worker earns about $170 a month in Hungary, compared with about $1,700 a month in the United States. Do these figures indicate that Tungsram will be a low-cost producer? ANSWER. No. You must also know how productive these workers are. What matters is what you are getting relative to what you are paying for. In fact, GE estimates that the productivity of Hungarian workers is one-seventh that of its workers in the U.S. Since GE is paying only one-tenth the wages but getting one-seventh the productivity, these figures taken together indicate that Tungsram should produce a light bulb 30% cheaper than GE's U.S. plants (1/10:1/7 = .70). In response, Philips recently took over Poland's leading lamp producer and another Western European competitor, Siemens' Osram unit, has acquired an East German producer. ADDITIONAL CHAPTER 17 QUESTIONS AND ANSWERS 1. Suppose the real value of the pound declines. How would this decline likely affect the economics of the IDC-U.K. project? ANSWER. If the real value of the pound declines, the dollar value of revenues on sales in England will undoubtedly decline. At the same time, however, dollar costs of production will also decline. The net effect on IDC-U.K. depends on what would have been done absent this project. If IDC-U.S. would have continued to service the U.K. market, then any reduction in revenues from the pound devaluation is irrelevant since it would not be incremental from the project's standpoint. In this case, we are left with the cost reduction and the net impact of pound devaluation on the project is unambiguously positive. In contrast, if export sales would have ceased in the absence of the IDC-U.K. project, then the net impact of a pound devaluation must take into account both the revenue decline and the cost reduction. The net impact depends critically on the price elasticity of demand. The odds are that the impact will be negative but only slightly. The reason for the word "slightly" is that dollar costs of production decline on 100% of IDC-U.K.'s output but sales of only half the output are affected by pound devaluation (the other half is sold to other EEC nations). 2. Describe the alternative ways to treat the interest subsidy provided by the British government. ANSWER. The interest subsidy provided by the British government can be incorporated in the investment analysis in one of two ways: a) Employ a weighted cost of capital, where the interest rate used in this cost figure is the subsidized rate. b) Explicitly include the subsidy (equal to the difference between the market interest rate and the subsidized rate multiplied by the subsidized principal amount) as one of the cash flows. 3. Under what circumstances should IDC-U.S. earnings on lost export sales to the United Kingdom and the rest of the Common Market countries be treated as a cost of the project? ANSWER. IDC-U.S. earnings on lost export sales to the U.K. and other EEC countries should be treated as a cost of the project if IDC-U.S. had sufficient excess capacity to have continued selling in the EEC in the absence of the IDC-U.K. project. 4. Under what circumstances should these lost export earnings be ignored when evaluating the project? 7 CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION ANSWER. The lost export earnings should be ignored when evaluating the project if the sales would have been lost anyway because (1) IDC- U.S. no longer had sufficient capacity to service both the U.S. market and the European market or (2) import restrictions would have kept out exports otherwise. 5. Should the cost of capital for the IDC-U.K. project be higher, lower, or the same as the cost of capital for a similar project to manufacture and sell diesel engines in the United States? Explain. ANSWER. There is no obviously correct answer to this question. However, three points that are relevant here. First, one of the major messages of modern financial theory is that the required return on a project depends on the riskiness of the project itself. Thus, the required return on the project should equal the required return on a similar investment undertaken in the United States only if the risks are the same. Second, the relevant risk that is priced and enters the cost of capital is the systematic risk of the project, not the project's total risk. Third, returns on the U.S. plant are strongly affected by variations in the U.S. economy--a major element of systematic risk. By contrast, returns on IDC-U.S.'s British venture are primarily affected by the state of the European economy, which is less related to factors that systematically affect returns on a well-diversified U.S. or world portfolio. The net result of these three points is that the cost of capital for IDC-U.K. is most likely to be less than the cost of capital for a similar project in the United States. 6. Some economists have stated that too many companies are not calculating the cost of not investing in new technology, world-class manufacturing facilities, or market position overseas. What are some of these costs? How do these costs relate to the notion of growth options discussed in the chapter? ANSWER. The company that gets to market first often goes on to dominate it. Those companies that don't invest early may quickly be out of the business altogether. They may also lose out on other opportunities that were not foreseen at the time of the investment decision, but that developed later. For example, a company that forgoes investment in a novel technology passes up the chance to explore its technical possibilities, market opportunities, development costs, and competitors' strategies. In other words, initial expenditures on product and process technologies and market position should be viewed as investments in information and in the creation of options to utilize that information in ways that may not have been envisioned originally. For example, Merck, the pharmaceutical firm, decided to invest in an automated packaging and distribution plan, even though the labor savings didn't justify the investment, in order to explore the potential benefits of plant automation. Results from the pilot project have clarified these benefits to the point that Merck is now expanding automation to its diverse manufacturing operations. Thus, firms that forgo investments in are passing up the chance to create and act on options. And the fact that a company passes up the chance to invest in options does not mean that its competitors will. For example, an auto maker may give up on ceramic engines, because technically they seem infeasible. But a rival who makes prosaic ceramic parts with the aim of one day using the knowledge to build a ceramic engine--as the Japanese are doing--can quickly change the competitive balance. Similarly, although liquid crystal displays (LCDs) are a U.S. invention (they were developed by RCA, which abandoned them as uneconomic), Japanese companies used them to make watches and small TVs; now they lead in LCD flat-panel computer screens. The ability to make these displays are a major reason Toshiba and other Japanese firms have won a large share of the laptop computer market. Moreover, the advanced display screens used in laptops not only are important as computer screens but also promise to open up huge markets in all types of display technology from cockpit, medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV. SUGGESTED SOLUTIONS TO CHAPTER 17 PROBLEMS 1. Suppose England raised its corporate tax rate by one percentage point. How would this affect the economics of the IDC-U.K. project? ANSWER. If the U.K. raised its corporate tax rate by one percentage point, the project's NPV would be minimally affected because IDC-U.S. can use all available foreign tax credits from IDC-U.K. 8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 7TH ED. 2. Suppose a firm projects a $5 million perpetuity from an investment of $20 million in Spain. If the required return on this investment is 20%, how large does the probability of expropriation in year 4 have to be before the investment has a negative NPV? Assume that all cash inflows occur at the end of each year and that the expropriation, if it occurs, will occur prior to the year-4 cash inflow or not at all. There is no compensation in the event of expropriation. ANSWER. This problem can be solved by breaking the cash flow stream into two components--one component if expropriation takes place and the other if no expropriation takes. The expected value of these streams is found by multiplying the first component by the probability that expropriation will take place and the other component by the probability that expropriation will not take place. Note that the cash flow streams are identical prior to year 4. All numbers are in millions of dollars. Year 0 1 2 3 4 5+ Cash flow with $20 $5 $5 $5 0 0 expropriation 20 Cash flow if no 5 5 5 5 5 expropriation If the probability of expropriation in year 4 is p, then the expected cash flows associated with this investment are: Year 0 1 2 3 4 5+ -$20 $5 $5 $5 $5(1 - p) $5(1 - p) The net present value of these cash flows, discounted at a 20% required return, is -20 + 5/1.2 + 5/(1.2)2 + 5/(1.2)3 + 5(1 - p)/(1.2)4 + ... + 5(1 - p)/(1.2)t + ... = -20 + 5/.2 - (5p/.2)/(1.2)3 = -20 + 25 - 14.68p Setting this quantity equal to 0 yields a solution of p = 34.1%. This means that the probability of expropriation has to be 34.1% before the investment no longer has a positive NPV. Note. The summation of the terms in the NPV equation uses the fact that the sum of an infinite annuity (a perpetuity) is a/r, where a is the annuity and r is the discount rate. Recognize also that the expected cash flow can be split into two annuities--one beginning in year 1 and equal to 5 per annum and the other beginning in year 4 and equal to -5p per annum. 3. Suppose a firm has just made an investment in France that will generate $2 million annually in depreciation, converted at today's spot rate. Projected annual rates of inflation in France and in the United States are 7% and 4%, respectively. If the real exchange rate is expected to remain constant and the French tax rate is 50%, what is the expected real value (in terms of today's dollars) of the depreciation charge in year 5, assuming that the tax write-off is taken at the end of the year? ANSWER. If the real exchange rate is expected to remain constant, then the real dollar value of the French franc is expected to decline at the same rate as the real franc value, namely the 7% French inflation rate. Hence, the real dollar value of the depreciation tax write-off will decline at the rate of 7% per annum. If the French tax rate is 50%, then a depreciation charge of $2 million is worth $1 million in today's dollars. If the real dollar value of this write- 7 CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION off is declining at the rate of 7% annually, then its real value in year 5, given that the write-off is taken at the end of the year, is $1,000,000/(1.07)5 = $712,986. 4. Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California, manufacturer of disk-drive controllers, is trying to decide whether to switch to offshore production. Given Xebec's well- developed engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking full advantage of both low-wage labor and a grab bag of tax holidays, low-interest loans, and other government largess. Most of his competitors seemed to be doing it. the faster he followed suit, the better off Xebec would be according to the conventional discounted cash-flow analysis, which shows that switching production offshore is clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of certain intangible strategic benefits associated with domestic production. a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its customers are all U.S. firms and that manufacturing technology--particularly automation skills--is key to survival in this business. ANSWER. Short-run benefits include better quality control, better communication with customers, and the ability to adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a laboratory in which to apply the latest thinking about automated production. By working with the production process on a daily basis, Xebec would have a better sense of the technology's wider potential, of possible applications that it would otherwise not think about. For example, running a highly automated manufacturing operation next door to the engineering group would enable Xebec to provide production-related input in the early stages of product design--something that offshore production managers can rarely do. And with successfully automated production, Xebec's new disk drives could be offered with a price and quality level to match those of potential competitors from Japan or anywhere else. By contrast, contracting to have its products built for it by a potential competitor in a country like Taiwan or Japan might cost Xebec both market share and its technological edge. The video recorder is a classic example of how production know-how can yield important technical advances. Sony, along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professional-use product from the United States that cost $20,000 or more and turned it into a $1,500 home product with a relatively small market. Japanese designers then worked closely with Japanese factories to make every component smaller and less expensive. Cooperation between Matsushita's design teams and employees on the shop floor eliminated more than three-quarters of the product's cost while dramatically improving its quality. In the process, the company turned a niche product into the mass-market success story of the 1980s. b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing (which are intangible costs of offshore production) into the factory location decision? ANSWER. The intangible strategic benefits of domestic manufacturing can be factored into the factory location decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and benefit from expanding into new products or markets or new process technologies. Whether Xebec will exercise these growth options depends on what happens in the future, which is unknowable today. The value of these growth options depends on several factors: 1. The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before responding to changes in the marketplace (since automation enables it to respond so quickly once it decides to). The investment in automation also provides Xebec with a set of long-lasting skills. 8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 7TH ED. 2. The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in automation is likely to be especially valuable since it so risky. 3. The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options. 4. The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared with others. Learning about the automation process is clearly a proprietary skill and so more valuable than investing in a new piece of equipment that everyone has access to. Valuing an investment in automation which embodies discretionary follow-up projects requires an expanded net present value rule that considers the attendant options. More specifically, the value of an option to undertake a follow-up project equals the expected NPV from investing in the project using the conventional discounted cash flow analysis plus the value of the discretion associated with undertaking the project. c. How would the possibility of radical shifts in manufacturing technology affect the production location decision? ANSWER. The possibility of radical shifts in manufacturing technology would increase the benefits from investing in factory automation in the U.S. The phrase "radical shifts" implies that the project is high risk, which increases the option component of value. For example, companies that in the mid-1970s made the transition from electro-mechanical manually operated machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities--much higher performance at much lower cost--of the microprocessors and microcontrollers that became available in the early 1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when they became available. Companies that had deferred investment in the emerging electronic technology were not able to participate in the great technological advances in microelectronics; they had not acquired an option in this new process technology. d. Xebec is considering producing more-sophisticated drives that require substantial customization. How does this possibility affect its production decision? ANSWER. The more customization is required, the more important it is to work closely with the customer. To meet the exacting needs of customers, there must be close personal contract between Xebec's engineering and production staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of the marketing, engineering, design, and manufacturing people when they are spread around the globe. The need for coordination increases the value of domestic production facilities. e. Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to Xebec to build a factory there. The loan would be paid off in equal annual installments over a five-year period. If the market interest rate for such an investment is 14%, what is the before-tax value of the interest subsidy? 9 CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION ANSWER. Borrowing at 5% when the market rate of interest is 14% saves Xebec 9% annually on the principal balance outstanding. This leads to annual before-tax savings and their associated present values as follows: Interest PV Factor Present Year Principal Savings (@ 14%) Value 1 $10,000,000 $900,000 .8772 $789,480 2 8,000,000 720,000 .7695 554,040 3 6,000,000 540,000 .6750 364,500 4 4,000,000 360,000 .5921 213,156 5 2,000,000 180,000 .5194 93,492 Total $2,014,668 The value of this five-year stream of cash, discounted at 14%, is $2,014,668. f. Projected before-tax income from the Taiwan plant is $1 million annually, beginning at the end of the first year. Taiwan's corporate tax rate is 25%, and there is a 20% dividend withholding tax. However, Taiwan will exempt the plant's income from corporate tax (but not withholding tax) for the first five years. If Xebec plans to remit all income as dividends back to the United States, how much is the tax holiday worth? ANSWER. Very little. Assuming that Xebec doesn't have any excess foreign tax credits (FTCs), it will owe the difference between the 20% withholding tax on dividends and the 34% rate levied by the IRS on its Taiwanese income. Xebec's after-tax income from Taiwan, with and without the tax holiday, will be: Taiwan No Tax Holiday Tax Holiday PBT $1,000,000 PBT $1,000,000 PAT (tax @ 25%) 750,000 PAT (no tax) 1,000,000 Dividend 750,000 Dividend 1,000,000 Withholding tax (@ 20%) 150,000 Withholding tax (@ 20%) 200,000 Net Dividend to Xebec $600,000 Net Dividend to Xebec $800,000 United States U.S. tax owed (@ 34%) $340,000 U.S. tax owed (@ 34%) $340,000 Direct FTC 150,000 Direct FTC 200,000 Indirect FTC 250,000 Indirect FTC 0 Net U.S. tax owed ($60,000) Net U.S. tax owed $140,000 PAT to Xebec $600,000 PAT to Xebec $660,000 Assuming that Xebec has no use for excess foreign tax credits, the calculations show that the value of the tax holiday to it is only about $60,000 annually. g. An alternative sourcing option is to shut down all domestic production and contract to have Xebec's products built for it by a foreign supplier in a country such as Japan. What are some of the potential advantages and disadvantages of foreign contracting vis-á-vis manufacturing in a wholly owned foreign subsidiary? ANSWER. See the answer to part a.
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