Question

Parrott Co is a UK based company. It is considering a 3 year project in Farland.

The project will require an initial investment of 81 m Farland Florins (FFI) and will have a residual value of 10m

The project's pre-tax net FFI inflows are expected to be:

Year 1 35m
Year 2 80m
Year 3 50m

The UK parent company will charge the overseas project with £2m of management charges each year.
The current spot rate is 5FFI - £1. UK inflation is expected to be 4% per year, and Farland inflation is expected
to be 7% per year.
Farland tax is 20% and is paid immediately. Any losses are carried forward and netted off the first available prof
purposes. Tax allowable depreciation will be granted on a straight line basis, and any residual value will be tax
UK tax is 30% and is payable 1 year in arrears.
Parrott Co recently undertook a similar risk project in the UK and used 11% as a suitable discount rate.

Required:
Calculate the NPV of the project in GBP

Solution

Calculation of Net Present Value [ NPV ]

T0 T1 T2
Particulars
In Farland Florins [ FF ] mn

a Initial Investment (81.00)

b Pre-tax cash inflows 35.00 80.00
c Management expenses [ WN 2 ] (10.29) (10.59)
d Tax on taxable income - (8.02)
e Residual Value
f Tax on residual value @ 20%
g Net cash flows in FFI [ - a + b - c - d + e - f ] (81.00) 24.71 61.39

T0 T1 T2
Particulars
In GBP mn
h Exchange rate 5.00 5.14 5.29
i Net cash flow in GBP [ g / h ] (16.20) 4.80 11.60
j Management fees income 2.00 2.00
k UK tax on above (0.60)
l Total cash flow in GBP [ i+ j - k ] (16.20) 6.80 13.00
m DF @ 11% 1.000 0.901 0.812
n DCF [ l * m ] (16.20) 6.13 10.56

Net Present Value 6.41

Working Notes

WN 1 - Calculation of exchange rates

Current spot rate : 1 GBP = 5 FFI

Base Currency GBP 4%

Counter currency FFI 7%

Using PPPT : S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ]
S1 = Spot rate in the future
S0 = Current spot rate
Hc = Inflation in counter currency
Hb = Inflation in base currency

For Year 1 5.1442

For Year 2 5.2926

For year 3 5.4453

WN 2 - Conversion of Management fees into FF

Annual management fees 2 GBP

At end of year 1 [ T1 ] 10.29 FF

At end of year 2 [ T2 ] 10.59 FF
At end of year 3 [ T3 ] 10.89 FF

WN 3 - Calculation of depreciation and tax saving on depreciation

SLM Depreciation per annum = [ Cost ( - ) Estimated residual value ] / Estimated useful life
SLM Depreciation per annum = [ 81 - 10 ] / 3 = 23.67

In this question, there is tax on residual value of 10 mn @ 20%

If we again deduct residual value and calculate depreciatiom, per annum depreciation is 23.67
If we do not deduct residual value and calculate depreciation, it will be 81 / 3 = 27
Each year, we are charging 3.33 less depreciation if we deduct residual value.
So, if we follow this approach, then, we are subjecting the 10mn to tax twice over.

So, tax allowable depreciation will be 81 / 3 = 27 mn

This approach is to be used only when tax is on residual value

Usually, tax is on 'balancing charge' or deduction is for 'balancing allowance'

WN 4 - Calculation of taxable profits and tax

Particulars T1 T2 T3
Pre-tax inflows 35 80 50
Less: Management expenses -10.29 -10.59 -10.89
Less: Depreciation -27 -27 -27

Profit before tax -2.29 42.41 12.11

Less: FF Tax 0 -8.02 -2.42

Loss of T1 will be carried forward and netted off agains profit of T2

So, taxable profit of T2 = 42.41 ( - ) 2.29 = 40.12
Tax @ 20% on 40.12 8.02

** The Profit before tax value is arrived at, after deducting 27 mn depreciation
So, the tax values calculated have already incorporated the tax saving impact of depreciation

WN 5 - UK Tax calculation

Particulars Year 1 Year 2 Year 3

Profit before tax [ in FF ] - 40.12 12.11
Exchange rate 5.14 5.29 5.45
Profit before tax [ in GBP ] - 7.58 2.22
Tax @ 10% differential rate - 0.76 0.22
Tax on management fees @ 30% 0.60 0.60 0.60
Total tax paymenr 0.60 1.36 0.82
Timing of tax payment T2 T3 T4
will have a residual value of 10m FF.

ent charges each year.

d Farland inflation is expected

netted off the first available profits for tax

any residual value will be taxable at 20%.

suitable discount rate.

Exchange rates
Management fees
Depreciation
Tax saving

T3 T4
d Florins [ FF ] mn

50.00
(10.89)
(2.42)
10.00
(2.00)
44.69 GBP FF
1 5
T3 T4 16.2 81
n GBP mn
5.45
8.21
2.00
(1.36) (0.82)
8.85 (0.82)
 0.731 0.659
6.47 (0.54)

GBP FF
1 5.1442
2.0000 10.29

d useful life

ation is 23.67
depreciation
Question

Puxty plo is a specialist manufacturer of window frames. Its main UK manufacturing operation is based in the so
of England, from where it distributes its products throughout the UK.
The directors are now considering whether they should open up an additional manufacturing operation in France
which they believe there will be a good market for their products.
A suitable factory has been located just outside Paris that could be rented on a 5-year lease at an annual charge o
payable each year in advance. The manufacturing equipment would cost €75m, of which €60m would have to b
the start of the project, with the balance payable 12 months later.

At the start of each year, the French factory would require working capital equal to 40% of that year's sales reve
expected that the factory will be able to produce and sell 80,000 window units per year although, in the first year
of the need to 'run in' the machinery and its new workforce, output is only expected to be 50,000 window units. E
is likely to be sold for €750, a price that represents a 150% markup on cash production costs.

The French factory would be set up as a wholly-owned subsidiary of Puxty plc. In France, 25% straight-line dep
cost is an allowable expense against company tax. Corporation tax is payable at 40% at each year-end without de
unused losses can be brought forward for set off against the following year's profits. No UK tax would be payab
after-tax French profits.

All amounts in € are given in current terms. Annual inflation in France is expected to run at 6% per year in the f
All € cash flows involved are expected to increase in line with this inflation rate, with the exception of the factor
cost of the manufacturing equipment, both of which would remain unchanged.

The French factory would be producing windows to a special design patented by Puxty. To protect its patent righ
charge its French subsidiary a fixed royalty of £20 per window. This cost would be allowable against the subsidi

The current €.../£1 spot rate is 1.5. Inflation in the UK is expected to be 4% per year over the period. There are n
between France and the UK.

Puxty plc is an all-equity financed company that is quoted on the London Stock Exchange. Its shares have a beta
current annual return on UK Government Treasury Bills is 10% and the expected return on the market is 18%. I
Tax is payable at 35%, one year in arrears.

Puxty operates on a 5-year planning horizon. At the end of five years, assume that working capital would be full
production equipment would have a scrap value, at that time, of €70m before tax.

Proceeds on asset sales are taxed at 40%. Assume all cash flows arise at the end of the year to which they relate,

Required:
Evaluate the proposed investment in France and recommend what investment decision should be made by Puxty
assumptions you make and work all calculations rounded to nearest 10,000 (either € or GBP ) - i.e. €0.01 m or E
 Rough Notes
cturing operation is based in the south
Annual lease rental : pyable at the start of each year
manufacturing operation in France - Machine cost : 60 mn at T0; 15 at T1
WC is 40% of sales
5-year lease at an annual charge of €3.8m,
m, of which €60m would have to be paid at

ual to 40% of that year's sales revenues. It is

per year although, in the first year, because
ected to be 50,000 window units. Each window
oduction costs.

c. In France, 25% straight-line depreciation on

at 40% at each year-end without delay and any
profits. No UK tax would be payable on the

cted to run at 6% per year in the foreseeable future.

te, with the exception of the factory rental and the

by Puxty. To protect its patent rights, Puxty plc will

ld be allowable against the subsidiary's French tax liability.

r year over the period. There are no remittance restrictions

k Exchange. Its shares have a beta value of 1.25. The

cted return on the market is 18%. In the UK Corporation

that working capital would be fully recovered and the

nd of the year to which they relate, unless otherwise stated.

decision should be made by Puxty plc. State clearly any

ther € or GBP ) - i.e. €0.01 m or E0.01m.
al : pyable at the start of each year
mn at T0; 15 at T1
 Solution

Calculation of Net Present value

T0 T1 T2
Particulars
In € ( rounded off to nea

a Initial Investment in assets (6,000) (1,500)

b Revenue [ WN 2 ] 3,975 6,742
c Operating cost [ WN 3 ] (1,590) (2,697)
d Lease rentals paid in advance (380) (380) (380)
e Royalty [ WN 4 ] (153) (249)
f Working capital flows [ WN 2 ] (1,590) (1,107) (162)
g Tax payment - (607)
h Scrap value
i Tax on scrap value
j Total cashflows [ - a + b - c - d - e +/- f - g + h -i] (7,970) (755) 2,647

T0 T1 T2
Particulars
In GBP ( rounded off to ne

k Exchange rate 1.50 1.53 1.56

l Total cash flow [ in GBP ] (5,313) (494) 1,699
m Royalty income 100 160
n Tax on royalty (35)
o Net cash flows [ l + m - n ] (5,313) (394) 1,824
p DF @ 20% 1.000 0.833 0.694
q DCF [ o * p ] (5,313) (328) 1,266

Net Present Value 143

 T3 T4 T5 T6
In € ( rounded off to nearest 10000 )

7,146 7,575 8,029

(2,858) (3,030) (3,212)
(380) (380)
(254) (259) (264)
(172) (182) 3,212 GBP €
(711) (812) (1,669) 1 1.5
7,000 5,313 7970
(2,800)
2,771 2,912 10,296

T3 T4 T5 T6
n GBP ( rounded off to nearest 10000 )

1.59 1.62 1.65

1,744 1,799 6,240
160 160 160
(56) (56) (56) (56)
1,848 1,903 6,344 (56)
0.579 0.482 0.402 0.335
1,070 918 2,550 (19)
Working Notes

WN 1- Calculation of exchange rates

Current spot rate : 1 GBP = 1.5 €

Base Currency GBP 4%

Counter currency € 6%

Using PPPT : S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ]
S1 = Spot rate in the future
S0 = Current spot rate
Hc = Inflation in counter currency
Hb = Inflation in base currency

For Year 1 1.53

For Year 2 1.56

For year 3 1.59

For year 4 1.62

For year 5 1.65

WN 2 - Sales and Working capital

Cost 100 300

Mark-up 150
Selling price 250 750

Year 1 Year 2 Year 3

Number of units sold 50,000 80,000 80,000
Selling price per unit (current terms) 750 750 750
Selling price per unit (after inflation) 795 843 893
Total sales [ units * selling price per unit] 39,750,000 67,416,000 71,460,960
Sales [ in 10000 ] 3,975 6,742 7,146
Working capital requirement [ 40% of sales ] 1,590 2,697 2,858
Working capital flows (1,590) (1,107) (162)
Timing of working capital flows T0 T1 T2

WN 3 - Production costs

Year 1 Year 2 Year 3

Number of units produced 50,000 80,000 80,000
Cost per unit [ current price terms ] 300 300 300
Cost per unit [ after inflation ] 318 337 357
Total cost of production 15,900,000 26,966,400 28,584,384
Cost [ in 10000 ] 1,590 2,697 2,858

WN 4 - Calculation of royalty

Year 1 Year 2 Year 3

Number of units sold 50,000 80,000 80,000
Royalty per unit in GBP 20 20 20
Total royalty 1,000,000 1,600,000 1,600,000
Exchange rate 1.53 1.56 1.59
Royalty in Euro 1,528,846 2,493,195 2,541,141
Royalty [ in 10000 ] 152.88 249.32 254.11

WN 5 - Depreciation

Depreciation is 25% Straight line on cost

Annual Depreciation = 75mn * 25% 18,750,000
Annual depreciation [ in 10000 ] 1,875

WN 6 - Calculation of profit and tax

Particulars Year 1 Year 2 Year 3

Revenue 3,975 6,742 7,146

Less: Costs (1,590) (2,697) (2,858)
Less: Royalty (153) (249) (254)
Less: Depreciation (1,875) (1,875) (1,875)
Less: Lease rentals (380) (380) (380)

Taxable profits in € (23) 1,541 1,779

Set-off of losses (23) -

Taxable profits in € after set-off - 1,518 1,779

Less: Tax @ 40% in France (607) (711)

Profit after tax 911 1,067

WN 7 - Calculation of cost of equity using CAPM

Ke = Rf + Beta * [ Rm - Rf ]
Ke = 10% + 1.25 * [ 18% - 10% ] = 20%
 Year 4 Year 5
80,000 80,000
750 750
947 1,004
75,748,618 80,293,535
7,575 8,029
3,030 3,212
(172) (182) 3,212
 T3 T4 T5

Year 4 Year 5
80,000 80,000
300 300
379 401
30,299,447 32,117,414
3,030 3,212

Year 4 Year 5
80,000 80,000
20 20
1,600,000 1,600,000
1.62 1.65
2,590,009 2,639,817
259.00 263.98

Year 4 Year 5

7,575 8,029
(3,030) (3,212)
(259) (264)
(1,875) -
(380) (380)

2,031 4,174
- -

2,031 4,174
(812) (1,669)

1,219 2,504