9.348 Corporate Finance Theory and Practicepage 1

9.348 Corporate Finance Theory and Practicepage 1

9.348 — Corporate Finance Theory and PracticePage 1

Assignment FourDr. D.A. Stangeland

Date Distributed:November 22, 1995

Due Date:December 1, 1995 (Friday)

Time Due:2:30 p.m.

Submissions:

You may submit your assignment to me or, in my absence, to Ms. Wiebe in room 455. Do not put your assignment in my or Ms. Wiebe’s mail box and do not slide your assignment under my or Ms. Wiebe’s door because it will then be considered late.

Early and Late Submissions:

You may submit your assignment late, however it will receive a mark of zero (0%). See the course syllabus for further details. If this assignment is submitted by 2:30 p.m., November 27, 1995, a bonus of up to 10% will be added to the score. The maximum score for an assignment including bonus is limited to 105%.

Material to submit:

a)for question 1: a maximum of 4 pages (single sided) -- neatly printed or word processed

b)for question 2: a maximum of 4 pages (single sided) -- neatly printed or word processed

Packaging:

Ensure that your name, and I.D.# are on all written material. Place the written material in an envelope, write your name and I.D.# on the outside of the envelope and submit it as indicated above.
Question One:

Management at Lowtax Corporation is considering whether to lease or buy some machinery that is required for the next 4 years. If a lease is used, the lessor will be Hightax Corporation. Data on the machinery is presented below:

Cost of machinery / $SID/10
CCA rate / 30%
Salvage value in 4 years / $200,000

The cost of low-risk debt financing is 10% (before tax) for both firms. If a lease is used, the lease payments would be payable in advance. The corporate tax rate for Lowtax Corporation is 25% and the corporate tax rate for Hightax corporation is 46%. Neither Lowtax nor Hightax anticipate owning any machinery in this asset class beyond the four years under consideration.

Part A:

Assuming this is a net-lease operating lease, what is the minimum lease charge that Hightax requires in order to supply the equipment to be leased to Lowtax? What is the maximum lease payment that Lowtax will pay before Lowtax management decides to switch to buying? Can the two parties agree upon a suitable leasing arrangement?

Part B:

Suppose that this operating lease was not a net lease. As a lessor, Hightax would be required to sign a servicing contract requiring yearly payments (in advance) from Hightax of $10,000. If Lowtax owned the machinery, it would also be required to enter into a servicing contract, but would not get as good terms as Hightax. Lowtax would be charged a fixed amount of $25,000 at the beginning of each year for four years.

Use this information to recalculate the minimum lease payment required by Hightax and the maximum lease payment payable by Lowtax. Can the two parties agree upon a suitable leasing arrangement?

Question Two:

Intercorp is considering constructing a project in the country of Hortonland.[*] Data for the project is presented below:

Initial cost / 8,000,000
Incremental Yearly Nominal Cash Flows (occurring at the end of each of years 1-5). / SID
Hortonland Tax Rate applicable to above yearly cash flows. / 50%

Staff in the Corporate Finance department have gathered the following macroeconomic data to compare Hortonland to Canada:

Canada / Hortonland
Risk-free rate of Interest / 8% / 12%
Expected Inflation Rate / 3%
Current Spot Rate of Exchange / 0.50 = $1.00 / $2.00 = 1.00

Notes:

  • Hortonland does not have an equivalent to CCA.
  • Hortonland is an open economy and the laws of relative purchasing power parity, and interest rate parity hold fairly well.
  • A Canadian project of this risk would be discounted using a rate of 14% in Canada.

Part A:

Use NPV analysis to determine whether or not this project should be accepted. What is the NPV in Canadian dollars? What is the decision given the above information?

Part B:

Hortonland is a country consisting of two states. The state in Hortonland where you are proposing your project, Robinsland, is subject to some political uncertainty. The ethnic Robins there want a veto over political decisions made in the National Assembly of Hortonland. The other state, dominated by the ethnic Stangs, have rejected the demands of the Robins. All of this has culminated in a separation movement gaining growing support. If the separatists win, there is fear that they may try to nationalize many of the foreign-owned industries in Robinsland.

Assuming the NPV calculations above yield a positive result and Intercorp invests in Robinsland, what strategies can Intercorp undertake to protect their investment?

[*] Note, the national currency of Hortonland is the Donut -- denoted as .