Partial exam – V13

Business Simulations
Name…Mara Dumitru-Alexandru

GoT Inc., an US based company, is considering the development of a subsidiary in

China that would manufacture tennis rackets locally. GoT’s management has asked
various departments to supply relevant information for a capital budgeting analysis. In
addition, some GoT executives have met with government officials in China to discuss
the proposed subsidiary. The project would end in 10 years. All relevant information
follows:

1. Initial investment. An estimated 1.400.000.000 CNY (which includes plant,

equipment and funds to support working capital) would be needed for the project.
Given the existing spot rate of 7 CNY per USD, the USD amount of the parent’s
initial investment is 200 million USD.

2. GoT will sell the tennis rackets on the following market: Germany, Mexico and
China.
The estimated price and demand schedules during the next 10 years are shown here:
- In Germany the price is 180 Euro and the demand is 100.000 units
- In Mexico the price is 3800 MXN and the demand is 50.000 units
- In China the price is 1500 CNY and the demand is 200.000 units
GoT has an agreement with EP, a Chinese seller, to sell, in the first 5 years, 60.000
units annually at the fixed price of 1050 CNY.

3. Costs. The variable costs (for materials, labor, etc.) per unit have been estimated at
800 CNY/unit. Fixed annual costs are 20 million CNY.

4. Depreciation. The China government will allow GoT’s subsidiary to depreciate the
cost of the plant and equipment at a maximum rate of CNY 80 million per year,
which is the rate the subsidiary will use.

5. Taxes. The China government will impose a 30 percent tax rate on income. In
addition, it will impose a 15 percent withholding tax on any funds remitted by the
subsidiary to the parent. The GoT subsidiary plans to send all net cash flows
received back to the parent firm at the end of each year. 1 YEAR 2 YEAR 3 YEAR 4

6. Exchange rates. The spot exchange rates are: 1 USD = 0,9 EURO, 7 CNY, 20 MXN.

7. Salvage value. The China government will pay the parent the salvage value to
assume ownership of the subsidiary at the end of 10 years.
8. Required rate of return. GoT, Inc., requires a 10 percent return on this project.

Questions:

1. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project,
assuming that GoT respects the agreement with EP. Based on calculated NPV (net
present value) should GoT establish a subsidiary in China under these conditions?

I believe that the company should not establish a subsidiary in China due to the
negative net present value.

2. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project
assuming that GoT does not respects the agreement with EP. Should GoT establish a
subsidiary in China under these conditions? Based on calculated NPV should GoT
respects the agreement with EP?

I think GOT should respect the agreement in order to increase the net present value
after 10 years. Under these circumstances the company should not open a subsidiary in
China.

3. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project and
find out the NPV (net present value) of the investment assuming that the USD is
depreciating with 2% y-o-y from the CNY (Use the capital budgeting analysis you have
identified as the most favorable from questions 1 and 2 to answer this question).

I chose the situation from question 1.

4. Since future economic conditions in China are uncertain, please find out how critical the
salvage value is in the alternative you think is most feasible (Use the capital budgeting
analysis you have identified as the most favorable from questions 1, 2 and 3 to answer
this question).

I used question 3 situation

5. The average annual inflation in China is expected to be 10 percent. Unless prices are
contractually fixed, revenue, variable costs, and fixed costs are subject to inflation and
are expected to change by the same annual rate as the inflation rate. The CNY is
depreciating with 5% y-o-y from the USD (Use the capital budgeting analysis you have
identified as the most favorable from questions1, 2 and 3 to answer this question).

I used question 3 situation

6. The shareholders are expecting more from the proposed project. Using a spreadsheet,
conduct a capital budgeting analysis for the proposed project and find out the NPV (net
 present value) of the inve1,stment if the required rate of return is 15% (Use the capital
budgeting analysis you have identified as the most favorable from questions1, 2 and 3 to
answer this question).

I used the question 3 situation.

7. Recently, a Chinese manufacturer called Skates’n’Stuff contacted GoT regarding the

potential sale of the company to GoT. Skates’n’Stuff entered on the market a decade
ago and has generated a profit in every year of operation. Furthermore, Skates’n’Stuff
has established distribution channels in China. Consequently, if GoT acquires the
company, it could begin sales immediately and would not require an additional year to
build the plant in China. Initial forecasts indicate that GoT would be able to sell 560,000
units annually at the price of 1600 CHY. Skates’n’Stuff’s CFO has indicated that he
would be willing to accept a price of 2,2 billion CNY in payment for the company, which
is clearly more expensive than the 1400 million CNY outlay that would be required to
establish a subsidiary in China. The depreciated amount will be 100 million CNY/ year.
The salvage value, after 10 years, is 1,2 billion CNY. All the other condition remained the
same.

What should they do? They should buy Skates’n’Stuff? Which should be the fair price for
the acquisition?

I believe they should purchase the company because the net present value is
lower in this scenario.