CHAOLANDIA'S SUPER-WIDGETS
In late 2000 the manager of Aggressive Enterprises in Chaolandia submitted the superwidgets project for approval by the parent company. Chaolandia was a developing country and Aggressive Enterprises operated there in the form of a locally-incorporated subsidiary.
ProductSuper-widgets. Aggressive Enterprises had been manufacturing widgets in Chaolandia. The new project would allow the country to produce more powerful widgets, super-widgets.
Investment Requirements It was estimated that 250,000 Chaolandia pesos (CP) would be required for plant and equipment. There was no parent investment in working capital. However, CP100,000 of the CP250,000 required for plant and equipment could be provided by the parent out of obsolete equipment it maintained in its warehouse. Chaolandia's government was agreeable to this transfer. The government also agreed to a 5-year, straight-line depreciation method for the CP250,000 of plant and equipment.
Project LifeAlthough the market for super-widgets was expected to continue expanding for at least the next 20 years, Chaolandia's government insisted on making arrangements for the purchase of the company by the government after 5 years. At that time, the government proposed to purchase the super-widget plant for CP450,000.
DemandAt a price of CP600 per unit, the demand for super-widgets was estimated as indicated in the following table:
DomesticExports
(units)(units)
2001 175 60
2002 250 100
2003 275 125
2004 300 175
2005 300 175
The domestic demand was considered to be completely price inelastic. That is, for the likely prices in the future, the quantity demanded appeared to be independent of the price charged. However, this was not the case with exports. Export demand was considered to be more responsive to price changes. It was thought that for each 1% increase in prices, the export quantity demanded decreased by 1.1%. The growth in export quantity anticipated in the table represented the expected penetration of the export market at the initial price of $200 (CP600). The export figures did not take into account any possible change in export prices. Chaolandia's exports could affect the sales of some of the other divisions of Aggressive Enterprises. However, this impact was expected to be nominal at least during the first 5 years of the project.
PricesThe engineers had estimated that an initial price of CP600 was appropriate, given the competition. However, historical inflation in the country made it possible to count on an annual 25% increase in prices. The CP600 for 2001 already incorporated the rate of inflation between 2000 and 2001.
Variable CostsVariable costs were estimated by the engineering department as shown in the following table:
Raw Material
DomesticCP160 per unit
Imported 95 per unit
Labor 50 per unit
Domestic costs were expected to increase at an annual rate of 29% because of inflation in the industry and labor contracts. Import prices were subject to fluctuations in the exchange rate. Cost estimates for 2001 already incorporated the rate of inflation between 2000 and 2001.
Fixed CostsThe estimates of fixed costs are provided in the following table:
Supervisory fees to the parentCP25,000 annually
Selling and Administrative expensesCP20,000 annually
DepreciationCP50,000 annually
The supervisory fees had been approved by Chaolandia's government and were to remain fixed for the 5-year life of the project. In fact, these fees were a form of royalty and did not involve additional expenditures at home. Selling and administrative expenses were subject to a 25% inflation rate per annum. Depreciation was to be based on a straight-line method, as approved by Chaolandia's government.
Exchange RatesThe economics department of Aggressive Enterprises had forecast the exchange rates listed in the next table:
CP per $
20003.00
20013.00
20023.50
20033.50
20043.75
20053.75
Taxes Taxes were as follows:
Chaolandia's Taxes:15% income tax, with no loss carry forward
30% withholding tax on dividends
Parent Country Taxes:On income: 45% allowing tax credit for taxes paid abroad
On capital gains: 40%
Remittances There was no control on repatriation of earnings. It was expected that all the profits after taxes would be remitted to the parent company. Also, depreciation-generated funds would be repatriated.
Cost of Capital Applicable to Chaolandia This cost was estimated at 35%. The production of super-widgets in Chaolandia was not expected to alter the risk profile of Aggressive Enterprises.
QUESTIONS TO ADDRESS IN THE
CHAOLANDIA SUPER-WIDGETS WRITE-UP
1.Would you accept the project? What assumptions do you consider to be critical in your analysis?
2.How would you analyze the project if earnings repatriation were prohibited during the initial 4 years of the project?
3.How would you analyze the project if Aggressive Enterprises intended to continue operating Super-Widgets for the next 20 years (i.e., the government would not purchase it at the end of the fifth year) and a control on earnings repatriation existed which limited repatriation of earnings to 12% of annual income?
- Suppose Chaolandia's government and financial institutions offered various alternatives to financing the project, including several degrees of leverage with local funds but at a higher rate of interest than Aggressive Enterprises pays in the home country. How would you analyze the project if an independent financial package had to be created for its financing, and the relevant question becomes: What is the return on equity of Aggressive Enterprises?
This should be written up as a report. Do NOT simply answer these questions 1-2-3-4. The report should include introduction, analyses and recommendation sections. It should be well-thought out and organized with a logical flow. Major exhibits should appear at the end of the report and referred to in the write-up rather than interrupting the flow of the report itself.