The Office Automation Corporation is considering a foreign investment. The initial cash outlay will be \(10 million. The current foreign exchange rate is 2 ugans 5 \)1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all aftertax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year’s depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes.

1. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five year period?
2. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows?

Year 0 .......................... \(152.0ugans

Year 1 .......................... \)152.2ugans

Year 2 .......................... \(152.4ugans

Year 3 .......................... \)152.7ugans

Year 4 .......................... \(152.9ugans

Year 5 .......................... \)1 5 3.2 ugans

Step by step solution

01

Meaning of Dividends

An organization pays its shareholders a profit, which may be a portion of its profits and retained earnings. When an organization makes a profit and accumulates retained earnings, those reserves can either be contributed back to the company or disseminated as a profit to shareholders.

02

(a) Evaluating whether the Office Automation Corporation undertakes the investment

The Office Automation Corporation
(Values in millions of ugans)
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue	20.00	20.00	20.00	20.00	20.00
Less: Operating expense	10.00	10.00	10.00	10.00	10.00
Less: Depreciation (20 M/5)	4.00	4.00	4.00	4.00	4.00
Earnings before foreign taxes	6.00	6.00	6.00	6.00	6.00
Less: Foreign income tax (25%)	1.50	1.50	1.50	1.50	1.50
Earnings after foreign income taxes	4.50	4.50	4.50	4.50	4.50
Dividends repatriated Gross U.S. taxes	4.50	4.50	4.50	4.50	4.50
(40% of earnings before foreign taxes)	2.40	2.40	2.40	2.40	2.40
Less: Foreign tax credit	1.50	1.50	1.50	1.50	1.50
Net U.S. taxes payable	0.90	0.90	0.90	0.90	0.90
After-tax dividend	3.60	3.60	3.60	3.60	3.60
Exchange rate (2 ugans/$)	2.00	2.00	2.00	2.00	2.00
After-tax dividend (U.S. $)	$1.80	$1.80	$1.80	$1.80	$1.80

Working notes:

Dividends repatriated assume all earnings after foreign income taxes will be repatriated.

Calculation of PV of dividend

$\begin{array}{c}\mathbf{PV}\mathbf{of}\mathbf{dividend}\mathbf{=}\mathbf{After}\mathbf{tax}\mathbf{dividend}\mathbf{\times }{\mathbf{PV}}_{\mathbf{IFA}}\\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{.}\mathbf{80}\mathbf{\times }\mathbf{3}\mathbf{.}\mathbf{274}\\ \mathbf{=}\mathbf{\$}\mathbf{5}\mathbf{.}\mathbf{893}\mathbf{million}\end{array}$

Note: PV_IFA(16% for 5 years) is 3.274

Calculation of depreciation

$\begin{array}{c}\mathbf{Depreciation}\mathbf{=}\frac{\mathbf{Per}\mathbf{year}\mathbf{depreciation}}{\mathbf{Total}\mathbf{year}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{4}}{\mathbf{2}}\\ \mathbf{=}\mathbf{\$}\mathbf{2}\end{array}$

Calculation of PV of depreciation

$\begin{array}{c}\mathbf{PV}\mathbf{of}\mathbf{depreciation}\mathbf{=}\mathbf{Depreciation}\mathbf{per}\mathbf{year}\mathbf{\times }{\mathbf{PV}}_{\mathbf{IFA}}\\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{.}\mathbf{00}\mathbf{\times }\mathbf{3}\mathbf{.}\mathbf{274}\\ \mathbf{=}\mathbf{\$}\mathbf{6}\mathbf{.}\mathbf{548}\mathbf{million}\end{array}$

Net Present Value of the project
The PV of all the cash inflows equals ($5.893 + $6.548)	$12.441 million
Cost of project	10.000 million
Net present value of the project	$ 2.441 million

Since NPV is positive, accept the project.

03

(b) Evaluating whether Office Automation undertakes the investment

(in millions)
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
After-tax dividend received	3.60	3.60	3.60	3.60	3.60
Depreciation	4.00	4.00	4.00	4.00	4.00
Total (in ugans)	7.60	7.60	7.60	7.60	7.60
Exchange rate (ug/$1)	2.2	2.2	2.2	2.2	2.2
Cash inflow (U.S. $)	3.45	3.17	2.81	2.62	2.38
PVIF (16%)	0.862	0.743	0.641	0.552	0.476
PV (U.S. $)	2.97	+2.36	+1.80	+1.45	+1.13

Net Present Value of the project
PV of all the inflows equals	$ 9.71 million
Cost of project	10.00 million
Net present value of the project	$ 0.29 million

On a purely economic basis, the company should now reject the investment.

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