Partial exam – V12

Business Simulations
Name… Fălămaș Maria-Denisa

GoT Inc., an UK 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 1.080.000.000 CNY (which includes plant,

equipment and funds to support working capital) would be needed for the project.
Given the existing spot rate of 9 CNY per GBP, the GBP amount of the parent’s
initial investment is 120 million GBP.

2. GoT will sell the tennis rackets on the following market: USA, Mexico and China.
The estimated price and demand schedules during the next 10 years are shown
here:
- In USA the price is 200 USD and the demand is 90.000 units
- In Mexico the price is 4000 MXN and the demand is 50.000 units
- In China the price is 1600 CNY and the demand is 200.000 units
GoT has an agreement with EP, a Chinese seller, to sell, in the first 5 years, 80.000
units annually at the fixed price of 1000 CNY.

3. Costs. The variable costs (for materials, labor, etc.) per unit have been estimated at
600 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 50 million per year,
which is the rate the subsidiary will use.

5. Taxes. The China government will impose a 20 percent tax rate on income. In
addition, it will impose a 12 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.

6. Exchange rates. The spot exchange rates are: 1 GBP = 1,25 USD, 9 CNY, 25 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 an 15 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 because of the negative net present value the company should not establish a
subsidiary in China.

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 so that the net present value can be increased after 10
years. The company should not be opening a subsidiary in China in these circumstances.

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 GBP 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 15 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 GBP (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 investment if the required rate of return is 20% (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 550,000
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 billion CNY in payment for the company, which is
clearly more expensive than the 1080 million CNY outlay that would be required to
establish a subsidiary in China. The depreciated amount will be 120 million CNY/ year.
The salvage value, after 10 years, is 800 million 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 think they shouldn't buy the Skates'n'Stuff because the net present value is increasingly
negative.