Fin4101 problem1
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IT Top is considering expanding its business internationally by establishing a manufacturing facility in Oman. A capital budgeting analysis of the proposed project in Oman estimates a positive NPV of RM4 million, supporting the project. However, the analysis should also consider exchange rate fluctuations by performing sensitivity analysis using strengthening and weakening Omani Rial scenarios. Expanding internationally could provide competitive advantages for IT Top but the management must carefully evaluate risks and determine appropriate financing and hedging strategies.
Fin4101 problem1
- 1. Faculty of Management and Economics Accounting and Finance Department FIN4101 International Finance – Problem One IT Top is considering expanding its business and becoming an MNC. Having had some successes with its IT gadgets in the local market for some years, the management thought that it is best to move forward to sustain its businesses. There are several drivers to this decision, the prime one being the demand from its shareholders who are s in consensus that transparency in the corporate governance can be improved if the company operates in various markets; hence a way to mitigate the related agency problems although it is expected that the problems may be more challenging challenging. The BOD also agreed with the decision as it conforms to the fundamentals of international finance. In particular, the local demand of some of its cash-cows products seem to saturate; hence, it is time to identify the foreign demand, even it is very near aturate; , to home. The resulted international PLC may be different to the local ones as customizations to suit the foreign competitive environment will likely be different. When it successfully penetrates a foreign market through such conservative international trade, having a foreign subsidiary would be the next step as this will leverage the , comparative advantages of the country and any other arising market imperfections. Should having a foreign subs subsidiary proves to be a big challenge; the company can always choose other forms of international business including licensing, franchising and joint ventures. By becoming an MNC, IT Top needs to cautiously monitor its value using multinational valuation model due to various uncertainties are highly expected. These risks may be related to the exposure to international economic conditions, political risk and e exchange rate risk. As a result of the i increases in uncertainty, investors tend to demand high rate of return that it can generate from the uncertain future cash flows. The first foreign market that IT Top will select must be decided after a thorough select country risk analysis is performed. Once it become familiar with the analysis, it can becomes confidently choose other countries in the future. Among the political risk characteristics, attitude of consumers in the host coun country such as high patriotism is arguably the most important one as this will translate into good or bad business. Furthermore, the management needs to identify actions of the host government in the form of tax burdens, incentives and subsidiary ownership. War threat and high level of corruption ns, are also amongst the risk characteristics. Analysis of financial risks that affect the inancial risk country economic growth should follow. This an th analysis may include studying the recent ay GDP, interest rates, exchange rates and inflation rates. The expected outcome of country risk analysis is to come up with a country risk rating. rating Although there are some independent researchers who may provide IT Top with such
- 2. rating for a fee, it is wise for the company to measure country risk by itself. Measuring macro-assessment and micro-assessment can be conducted via checklist approach, Delphi technique, quantitative, inspection visits or combination of these techniques. By using proper scoring to individual risk characteristics and reliable weights, IT Top can produce country risk rating from which it can select the most desired foreign market. This risk analysis can also be incorporated into capital budgeting decision of a proposed foreign project. Finally, to support a country choice, IT Top needs to consider actions that can prevent host government takeovers via hiring local labour, borrowing local fund, insurance and the like. Having a foreign subsidiary in the form of real assets is considered a DFI which can boost profitability and enhance shareholder wealth. Both revenue-related and cost- related motives play important roles for a DFI decision. These motives or benefits can be compared among countries before selecting the most suitable one. These countries may also differ in their views of DFI, where some are very much encouraging DFI while some others pose many barriers to it. The country that IT Top finally chooses will likely affect its risk diversification. The most common challenging task of an international business is arguably in the capital budgeting, which IT Top must later face. Although the technique including NPV and IRR may not differ much, inputs included in the calculations will vary. An example of IT projects that can be used for IT Top can be found in appendix 1. The correct calculations of using the inputs will result in positive NPV of nearly RM4 million that can support the management to pursue the project. Nonetheless, it must also account for future fluctuation in the exchange rate so that a decision to hedge foreign exchange can be taken. A scenario of weakening or strengthening Omani currency is also given in appendix 1 to help IT Top practice such a sensitivity analysis. An MNC decision also impacts IT Top’s cost of capital and capital structure. Financing an MNC’s operations using domestic external sources of debt and equity may be good options for IT Top. Nevertheless, the decision must be based on the stability of the MNC’s cash flows, its credit risk, access to retained earnings and the expected agency problems. In addition, influence of host country characteristics must also be given attention. Consequently, the cost of capital of an MNC tends to differ from a domestic company. If IT Top often borrows substantial amounts, it may receive preferential treatment from creditors, thereby reducing its cost of capital. Further, if its expansion to Omani market achieved the desired level of diversification, its cost of capital may also decline. In the same manner, its beta can be reduced; hence, CAPM can be used to estimate the required rate of return. In this consideration, risk-free rate in Oman or any other countries should be reliably identified early before engaging the project. In short, expanding businesses across the Malaysian borders seems to enable IT Top achieving a desired competitive edge BUT if you were in the IT Top management team, what would you do?”
- 3. Appendix 1 Ganu Tab 10.1 is one of the recent IT Top products. It is special in terms of pre-installed applications that can attract Muslim users including Arabic dictionary of 80 languages, Quran recitations and Qiblah compass. IT Top has identified Oman as a suitable location for its foreign manufacturing facility. The following information is available for the management to perform a capital budgeting analysis on the project. 1. Initial investment - the project would require an initial investment of 2.5 million Omani Rial (OMR). Given the existing spot rate of RM8.00 per OMR, the MYR amount of IT Top investment is RM20 million. 2. Price and consumer demand – the estimated price and demand schedule during each of the next four years are: Year 1 Year 2 Year 3 Year 4 Price per tablet OMR125 OMR125 OMR110 OMR100 Demand in Oman 20,000 units 25,000 30,000 40,000 3. Costs – the variable costs per tablet have been estimated as: Year 1 Year 2 Year 3 Year 4 VC per tablet OMR60 OMR60 OMR70 OMR70 The expense of leasing office space is OMR100,000 per year. Other annual overhead expenses are expected to be OMR60,000 per year. 4. Tax laws – IT Top’s subsidiary is allowed to depreciate the facility cost at a maximum rate of OMR300,000. The Omani government will impose 25 percent rate on income as well as a 10 percent WHT on any funds remitted to IT Top. IT Top is eligible to a tax credit on tax paid in Oman. 5. Remitted funds – all net cash flows will be sent to IT Top at the end of each year. 6. Exchange rates – IT Top can use the current spot rate as its forecast rate for all future periods. 7. Salvage value – the Omani government is interested to purchase the manufacturing facility for OMR1 million at the end of 4 years and promises no capital gain tax on the sale. 8. Required rate of return – IT Top requires 16 percent rate of return on this project. 9. Sensitivity considerations – IT Top is also advised to perform sensitivity analysis of a strengthening and a weakening OMR scenario with a constant RM0.40 rise or RM0.40 fall in the exchange rate per year can be used.