21A-1. The Office Automation Corporation is considering a foreign investment.
The initial cash outlay will be $10 million. The current foreign exchange rate is 2 ugans _ $1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all after-tax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year's depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes.
a. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five-year period?
b. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows:
Year 0 . . . . . . . . . . $1 _ 2.0 ugans
Year 1 . . . . . . . . . . $1 _ 2.2 ugans
Year 2 . . . . . . . . . . $1 _ 2.4 ugans
Year 3 . . . . . . . . . . $1 _ 2.7 ugans
Year 4 . . . . . . . . . . $1 _ 2.9 ugans
Year 5 . . . . . . . . . . $1 _ 3.2 ugans
The solution explains capital budgeting in a foreign country
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