Cost of Capital and Global Investments

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The Gibson Company is a United States (US) firm that is considering a joint venture with Brasilia, DF, a Brazilian firm that grows and processes coffee beans. Gibson has a patent for a new coffee processing method. This intellectual property is motivating Gibson to expand beyond importing coffee to engaging in a joint venture to process the coffee. Gibson will invest $8 million in the proposed joint venture project, which will help to finance Brasilia 's production using the newly patented process.

The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at http://www.oanda.com.

For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.

The expected total profits resulting from the joint venture per year are as follows:

Year Total Profits from Joint Venture (in BRL)
1 40 million
2 60 million
3 70 million
4 90 million
5 120 million
Gibson's average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibson's US income tax rate is 10 percent. Gibson's capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates.
Gibson is concerned about country risk in the following two forms:
(1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs, Gibson will receive additional tax credits on its US taxes, ...