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  • FINS5516 2019T1 Week10 Practice Questionv2 PDF

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    1) The document discusses political risks associated with launching a butter robot project in a foreign land called The Citadel. It provides cash flow projections and calculates the NPV with and without political risk insurance. 2) The document also discusses transfer pricing between a Swiss and German affiliate. It analyzes the cash flow impact of raising transfer prices and lengthening credit terms between the affiliates. 3) The transfer pricing change allows a short-term shift of $900,000 in after-tax cash flows between the affiliates, saving $225,000 in taxes over the first 3 months.

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    1) The document discusses political risks associated with launching a butter robot project in a foreign land called The Citadel. It provides cash flow projections and calculates the NPV with and without political risk insurance. 2) The document also discusses transfer pricing between a Swiss and German affiliate. It analyzes the cash flow impact of raising transfer prices and lengthening credit terms between the affiliates. 3) The transfer pricing change allows a short-term shift of $900,000 in after-tax cash flows between the affiliates, saving $225,000 in taxes over the first 3 months.

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    99 views16 pages

    FINS5516 2019T1 Week10 Practice Questionv2 PDF

    Uploaded by

    Kelvin Chen
    1) The document discusses political risks associated with launching a butter robot project in a foreign land called The Citadel. It provides cash flow projections and calculates the NPV with and without political risk insurance. 2) The document also discusses transfer pricing between a Swiss and German affiliate. It analyzes the cash flow impact of raising transfer prices and lengthening credit terms between the affiliates. 3) The transfer pricing change allows a short-term shift of $900,000 in after-tax cash flows between the affiliates, saving $225,000 in taxes over the first 3 months.

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    of 16

    Week 10.

    Practice Questions
    Political Risks and Transfer pricing
    YEEJIN JANG
    Political Risks
    Your firm is considering launching its new product, the sentient Butter
    Robot C137, in the far off lands of The Citadel. The Butter Robot’s raison
    d’être is to serve sticks of butter to humans at the dining table. You
    estimate that the project will provide the following annual free cash
    flows (FCFs):
    Year 1 Year 2 Year 3 Year 4
    FCF $40 M $90 M $150 M $175 M
    The project would require an initial up-front investment of $74.00
    million. In addition, you estimate that the appropriate cost of capital for
    butter robot projects of this risk class is 25.0% per annum.
    Q1. Given the above, what is the NPV of the project? Would you accept
    the project?
    40 90 150 175
    𝑁𝑃𝑉 = −74 + + + + = $164.08 million
    1.25 1.252 1.253 1.254
    Q2. Due to the recent collision of The Citadel with a Galactic Federation
    prison, The Citadel is currently experiencing a severe fiscal crisis and the
    ruling council has threatened to nationalize foreign-owned assets. You
    now estimate that there is a 30% chance in any given year that your
    project assets will be expropriated without compensation. The cost of
    capital of 25.0% p.a. used in the previous question does not factor in
    any such risk of expropriation.
    What is the NPV of your project now? Would you accept the project?
    Probability-weighted cash flows: CFt*(1-p)t
    Year 0 Year 1 Year 2 Year 3 Year 4
    FCF -$74 M $40 M $90 M $150 M $175 M
    Prob-weighted -$74 M $28 M $44.1 M $51.45 M $42.02 M
    CFs
    40(1−0.3) 90(1−0.3)2 150(1−0.3)3 175(1−0.3)4
    𝑁𝑃𝑉 = −74 + + 1.252 + 1.253 + = $20.18 million
    1.25 1.254
    Q3. Your Federation Insurance Bureau contact, Jerry Smith, informs you
    that your firm can be provided with political risk insurance. This would
    compensate your firm with today’s estimate of the uninsured project’s
    NPV at the end of the year in which your assets were seized. The
    insurance contract requires payment of its $3.90 million annual fee at
    the start of each year of coverage.
    What is the NPV of your project now? Would you insure the project?
    The estimated NPV of $20.18m is the insurance compensation in the
    event of expropriation. Probability-weighted cash flows:
    [-Insurance premium + CFt]*(1-p)t+ Compensation*(1-p)t-1p
    Year 0 Year 1 Year 2 Year 3 Year 4
    FCF -$74 M $40 M $90 M $150 M $175 M
    Insurance premium -$3.9 M -$3.9 M -$3.9 M -$3.9 M
    Compensation $20.18 M $20.18 M $20.18 M $20.18 M
    Prob-weighted CFs -$77.9 M $31.32 M $46.43 M $53.08 M $44.09 M

    31.32 46.43 53.08 44.09


    𝑁𝑃𝑉 = −77.9 + + + 1.253 + 1.254 = $22.11 million
    1.25 1.252
    *Note: New credit terms (180-day extension) have applied to previous sales made
    Transfer Pricing
    Textbook p670 Problem 2.
    Suppose a U.S. parent owes $5 million to its English affiliate. The timing
    of this payment can be changed by up to 90 days in either direction.
    Assume the following effective annualized after tax dollar borrowing
    and lending rates in England and the United States.
    Lending (%) Borrowing (%)
    United States 4.0 3.2
    England 3.6 3.0

    Differential England
    (US – England) - +
    United States - 3.2-3.0 = 0.2 3.2-3.6 = -0.4
    + 4.0-3.0 = 1.0 4.0-3.6 = 0.4
    a. If the U.S. parent is borrowing funds while the English affiliate
    has excess funds, should the parent speed up or slow down its
    payment to England?

    Differential England
    (US – England) - +
    United States - 3.2-3.0 = 0.2 3.2-3.6 = -0.4
    + 4.0-3.0 = 1.0 4.0-3.6 = 0.4
    ✓Since the British unit has the higher opportunity cost of funds,
    the U.S. parent should speed up its $5 million payment by 90
    days.
    b. What is the net effect of the optimal payment activities in
    terms of changing the units' borrowing costs and/or interest
    income?
    ✓ ($5,000,000 x (0.036-0.032) x 90/360 = $5,000 increase in
    total consolidated income
    Transfer Pricing
    Textbook p670 Problem 3.
    Suppose that DMR SA, located in Switzerland, sells $1 million worth of
    goods monthly to its affiliate DMR Gmbh, located in Germany. These
    sales are based on a unit transfer price of $100. Suppose the transfer
    price is raised to $130 at the same time that credit terms are
    lengthened from the current 30 days to 60 days.
    a. What is the net impact on cash flow for the first 90 days? Assume that the
    new credit terms apply only to new sales already booked but uncollected.

    Cash Inflows for Swiss Unit and Cash Outflows for German Unit
    Month 1 2 3
    New Terms $1,000,000 0 $1,300,000
    Old Terms 1,000,000 1,000,000 1,000,000
    Change 0 -$1,000,000 +$300,000
    Cumulative 0 -$1,000,000 -$700,000
    b. Assume the tax rate is 25 percent in Switzerland and 50
    percent in Germany and that revenues are taxed and costs
    deducted upon sale or purchase of goods, not upon collection.
    What is the impact on after tax cash flows for the first 90 days?

    Cash Flows for Swiss Affiliate

    Month 1 2 3
    New Terms
    Collection of receivables $1,000,000 0 $1,300,000
    Tax payments 1.3m sales * 25% -325,000 -325,000 -325,000

    Net cash inflow $675,000 -$325,000 $975,000

    Old terms
    Collection of receivables 1,000,000 1,000,000 1,000,000
    Tax payments 1m sales * 25% -250,000 -250,000 -250,000

    Net cash inflow $750,000 $750,000 $750,000

    Change in net cash inflow -$75,000 -$1,075,000 $225,000


    Cumulative change -$75,000 -$1,150,000 -$925,000
    Cash Flows for German Affiliate

    Month 1 2 3
    New Terms
    Payment of payables $1,000,000 0 $1,300,000
    Value of tax write-offs 1.3m COGS * 50% -650,000 -650,000 -650,000
    Net cash outflow $350,000 -$650,000 $650,000

    Old terms
    Payment of payables $1,000,000 $1,000,000 $1,000,000
    Value of tax write-offs 1m COGS * 50% -500,000 -500,000 -500,000

    Net cash outflow $500,000 $500,000 $500,000

    Change in net cash outflow -$150,000 -$1,150,000 $150,000


    Cumulative change -$150,000 -$1,300,000 -$1,150,000

    Swiss after-tax cash inflow drops by $925,000


    German after-tax cash outflow drops by $1,150,000
    → Transfer pricing change allows a shift of $900,000 over the first 90 days
    → The net effect of this income shift for the first three months is to save an amount
    of taxes equal to $900,000 x (.50 - .25) = $225,000.

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