Capital Budgeting
Questions Part I:
A:
1. Evaluate the tax shield from the interest tax deductibility
2. Evaluate the bonus from the subsidised loan granted by the European Bank for R&D
3. Calculate the Net Present Value of the project
4. Is it profitable for the FMI parent company?

B:
FMI thinks that, starting in year two, it will be the opportunity to export to Latin America, the 2000 Trucks which used to be exported to Romania.
What would be the impact on FMI?
C:
The leverage Ratio of RVI (Debt/ equity) is approximately 25%. Is this piece of information good news or a bad news for the profitability of the project?
Part II intro + questions
Before making the final decision, it is necessary to measure the risk, the risk premium, and the cost of capital more accurately.
This formal approach is worth doing because the EU Financial Market is transparent and financial information are reliable.
Of course, you could buy some pieces of information from financial agencies which publish financial data such as the beta, which is the key variable to measuring the risk premium.
However the access cost to such a financial data base is very expensive.
Using the same methodology as BLOOMBERG, you can evaluate your own BETA, based on the stock prices of FMI Company.
This French Company is quoted on the Paris Stock Exchange. 60 Monthly data
Stock prices of FMI, Market Index level, and 3 month Euribor, are available in the Data base: Monthly DATA
1 What is your computed BETA?
2 Given this BETA what should be the theoretical cost of capital?
3 What would your conclusions be?
Please see attached.
FM International (FMI)
Ford Motor Internation intends to build a new TRUCK assembly line in Romania. FMI Romania
Romania is a good advanced base in order to expand in the European countries, which transportation renewing needs are huge.
At this point in time, FMI, the parent company, exports 2000 vehicles each year in this eastern Zone. Its production capacity is nearly saturated, and if FMI wants to benefit from these new opening fast growing markets, investing is a necessary.
Romania has been chosen for many reasons. First many executives speak the English language; which facilitates the management; secondly, in the transition phase toward market economy, Romania is suffering from a high level of unemployment. And Romanian authorities are extremely interested in attracting such efficient companies capable of creating thousands of jobs.
The European Bank for Research and Development has agreed to 100 Million Euro 5 year loan, at 8%, redeemable in Fine; the interest being paid at the end each year.( the total amount of capital is repaid in one shot at the end of the 5th year; financial expenses are paid each year )
The total cost of the project is estimated at 500 Million Euro.
This new production line should be operational in 6 months. The skilled workers from the old "Dacia" automobile production units will be hired.
Because of the licensing contract, the Parent company will receive royalties which represent 7% of the revenue. On the top of that, FMI could also sell some spare parts with a margin of 20%.
The expected return on equity is 15% due to the risk of the project.
The Financing sources
The investment, 500 Millions Euro, will be linearly depreciated with a zero book value at the end of the 5 years.
As said, FMI benefits from a subsidised loan with a very favourable rate: 8%.
One half of the 400 Million missing will be financed with Equity and the other half with a loan of 200 Million, at 12% ( which is the market rate) redeemable within 10 years by constant annuity, with a deferred capital payment the first year; the first year only interests are paid.
Beyond the equipment in itself, we expect an increase of the Net Working Capital (Inventory + customer credit) which represents 30% of the revenue; a part of this NWC needs is financed by the supplier credit which corresponds to roughly 10% of sales.
The Romanian affiliate of the Credit Lyonnais will open a credit line of 120 Billion LEI (equivalent to 30Millions Euro) to finance the initial working capital. The change in the NWC will be self financed.
The Initial Balance sheet is as follow: (Millions euro)
ASSETS LIABILITIES
Plants & equipments 500 Equity 200
NWC 30 LT Loan from the E B R D 100
Debt from the Parent company 200
Debt Crédit lyonnais 30
TOTAL 530 TOTAL 530
Activity forecast:
The first year, the sales volume is estimated at 8000 units, with a unit price of 50 000 ?.
The sales volume should increase by 10% annually; to reach 10 648 Units five years later.
Obviously, these sales will replace the 2000 trucks which are presently exported in this east area, with a before tax margin of 25%.
Very important is the inflation rate which, on average, is 5% per month. The immediate consequence is the depreciation of the LEI.( cf the PPP theory)
In the first year, because of the 6 month operating delay, the production of the new unit will be only 4000 units. The missing 4000 units will be imported from the FMI parent company at a transfer price of 50 000?. (which means no profit for the Romanian affiliate). As said, starting from year two, the sales volume should increase by 10% annually.
Production Costs:
Production Costs will follow the inflation rate. Initially, the unit variable costs are 112 000 000 Lei (equivalent to 28000?); of which 6000? represent the price of the spare parts sold by the Parent company. This transfer price of the parts includes 25% of the Parent company overheads. In fact the variable production costs represent 75% of this transfer price.
The royalties paid to the Parent company will follow the expansion of the revenue.
The overheads of FMI Romania, for a full year, are estimated at 2.2 millions Euro; but for the first year this amount is reduced to 1 200 000 Euro.
Recall that the plants are depreciated linearly, which represents 400 Billion LEI each year
Tax system:
The Income tax rate is 45% in Romania; Any deficit can be carried forward for 5 years.
Net Working Capital needs:
The NWC needs are quite important for this type of project: The initial NWC is 30 Million ?. In average it's equal to 20% of sales.
The Market residual Value:
The valuation of he Market residual value of a project is a "tough" issue.
In our situation the Residual Value has been estimated to 3 times the Net cash flow of the 5th year;
Dividend payment :
.
The contract says that the Romanian affiliate has to pay all the free cash flows to the Parent company, after the repayment of different loans. Remember that FMI will perceive royalties too.
A 10% withhold tax is levied by the Romanian tax authorities.
In France the Income tax on this revenue is 33%.
Questions Part I:
A:
1. Evaluate the tax shield from the interest tax deductibility
2. Evaluate the bonus from the subsidised loan granted by the European Bank for R&D
3. Calculate the Net Present Value of the project
4. Is it profitable for the FMI parent company?

B:
FMI thinks that, starting in year two, it will be the opportunity to export to Latin America, the 2000 Trucks which used to be exported to Romania.
What would be the impact on FMI?
C:
The leverage Ratio of RVI (Debt/ equity) is approximately 25%. Is this piece of information good news or a bad news for the profitability of the project?
Part II intro + questions
Before making the final decision, it is necessary to measure the risk, the risk premium, and the cost of capital more accurately.
This formal approach is worth doing because the EU Financial Market is transparent and financial information are reliable.
Of course, you could buy some pieces of information from financial agencies which publish financial data such as the beta, which is the key variable to measuring the risk premium.
However the access cost to such a financial data base is very expensive.
Using the same methodology as BLOOMBERG, you can evaluate your own BETA, based on the stock prices of FMI Company.
This French Company is quoted on the Paris Stock Exchange. 60 Monthly data
Stock prices of FMI, Market Index level, and 3 month Euribor, are available in the Data base: Monthly DATA
1 What is your computed BETA?
2 Given this BETA what should be the theoretical cost of capital?
3 What would your conclusions be?
https://brainmass.com/business/capitalbudgeting/capitalbudgetingnetpresentvaluefinance43302
Solution Summary
The solution has the capital budgeting problem relating to the intention FMI to build a truck plant in Romania