Report on the proposed assembly plant in Kendwe
This report considers whether or not it would be beneficial for Yung Co to set up a parts assembly plant in Kendwe. It takes account of the financial projections, presented in detail in Appendices 1 and 2, discusses the assumptions made in arriving at the projections and discusses other non-financial issues which should be considered. The report concludes by giving a reasoned recommendation on the acceptability of the project.
Assumptions made in producing the financial projections
It is assumed that all the estimates such as sales revenue, costs, royalties, initial investment costs, working capital, and costs of capital and inflation figures are accurate. There is considerable uncertainty surrounding the accuracy of these and a small change in them could change the forecasts of the project quite considerably. A number of projections using sensitivity and scenario analysis may aid in the decision-making process.
It is assumed that no additional tax is payable in the US for the profits made during the first two years of the project's life when the company will not pay tax in Kendwe either. This is especially relevant to Year 2 of the project.
No details are provided on whether or not the project ends after four years. This is an assumption which is made, but the project may last beyond four years and therefore may yield a positive net present value. Additionally, even if the project ceases after four years, no details are given about the sale of the land, buildings and machinery. The residual value of these non-current assets could have a considerable bearing on the outcome of the project. It is assumed that the increase in the transfer price of the parts sent from the US directly increases the contribution which Yung Co earns from the transfer. This is probably not an unreasonable assumption. However, it is also assumed that the negotiations with Kendwe's Government will be successful with respect to increasing the transfer price and the royalty fee. Yung Co needs to assess whether or not this assumption is realistic.
The basis for using a cost of capital of 12% is not clear and an explanation is not provided about whether or not this is an accurate or reasonable figure. The underpinning basis for how it is determined may need further investigation.
Although the scenario states that the project can start almost immediately, in reality this may not be possible and Yung Co may need to factor in possible delays.
It is assumed that future exchange rates will reflect the differential in inflation rates between the respective countries. However, it is unlikely that the exchange rates will move fully in line with the inflation rate differentials.
(Up to 2 marks per assumption discussed- Max 9 marks)
Other risks and issues
Investing in Kendwe may result in significant political risks. The scenario states that the current political party is not very popular in rural areas and that the population remains generally poor. Yung Co needs to assess how likely it is that the Government may change during the time it is operating in Kendwe and the impact of the change. For example, a new government may renege on the current government's offers and/or bring in new restrictions. Yung Co will need to decide what to do if this happens.
Yung Co needs to assess the likelihood that it will be allowed to increase the transfer price of the parts and the royalty fee. Whilst it may be of the opinion that currently Kendwe may be open to such suggestions, this may depend on the interest the Government may get from other companies to invest in Kendwe. It may consider that agreeing to such demands from Yung Co may make it obligated to other companies as well.
The financial projections are prepared on the basis that positive cash flows from Kendwe can be remitted back to the US. Yung Co needs to establish that this is indeed the case and that it is likely to continue in the future.
Yung Co needs to be careful about its ethical stance and its values, and the impact on its reputation, given that a school is being closed in order to provide it with the production facilities needed. Whilst the Government is funding some of the transport costs for the children, the disruption this will cause to the children and the fact that after six months the transport costs become the parents' responsibility may have a large, negative impact on the company's image and may be contrary to the ethical values which the company holds. The possibility of alternative venues should be explored.
Yung Co needs to take account of cultural risks associated with setting up a business in Kendwe. The way of doing business in Kendwe may be very different and the employees may need substantial training to adapt to Yung Co's way of doing business. On the other hand, the fact that the population is well educated, motivated and keen may make this process easier to achieve.
Yung Co also needs to consider fiscal and regulatory risks. The company will need to assess the likelihood of changes in tax rates, laws and regulations, and set up strategies to mitigate eventualities which can be predicted. In addition to these, Yung Co should consider and mitigate, as far as possible, operational risks such as the quality of the components and maintenance of transport links.
Yung Co should assess and value alternative real options which it may have. For example, it could consider whether licensing the production of the components to a local company may be more financially viable; it could consider alternative countries to Kendwe, which may offer more benefits; it could consider whether the project can be abandoned if circumstances change against the company; and entry into Kendwe may provide Yung Co with other business opportunities.
(2–3 marks per issue/risk discussed- Max 11 marks)
(Max 17 marks)
Recommendation
The result from the financial projections is that the project should be accepted because it results in a positive net present value. It is recommended that the financial projections should be considered in conjunction with the assumptions, the issues and risks, and the implications of these, before a final decision is made.
There is considerable scope for further investigation and analysis. It is recommended that sensitivity and scenario analysis be undertaken to take into consideration continuing the project beyond four years and so on. The value of any alternative real options should also be considered and incorporated into the decision.
Consideration must also be given to the issues, risks and factors beyond financial considerations, such as the impact on the ethical stance of the company and the impact on its image, if the school affected is closed to accommodate it.
Report compiled by:
Date:
(3 marks)
Appendices
Appendix 1
Year |
0
KRm |
1
KRm |
3
KRm |
4
KRm |
5
KRm |
Sales revenue (W2) |
|
18,191 |
66,775 |
111,493 |
60,360 |
Parts costs (W2) |
|
(5,188) |
(19,060) |
(31,832) |
(17,225) |
Variable costs (W2) |
|
(2,921) |
(10,720) |
(17,901) |
(9,693) |
Fixed costs |
|
(5,612) |
(6,437) |
(7,068) |
(7,760) |
Royalty fee (W3) |
|
(4,324) |
(4,813) |
(5,130) |
(5,468) |
Tax-allowable depreciation |
|
(4,500)
______ |
(4,500)
______ |
(4,500)
______ |
(4,500)
______ |
Taxable profits/(loss) |
|
(4,354) |
21,245 |
45,062 |
15,714 |
Tax loss carried forward |
|
|
|
(4,354)
______ |
|
|
|
|
|
40,708 |
|
Taxation (40%) |
|
0 |
0 |
(16,283) |
(6,286) |
Add back loss carried fwd. |
|
|
|
4,354 |
|
Add back depreciation |
|
4,500
______ |
4,500
______ |
4,500
______ |
4,500
______ |
Cash flows after tax |
|
146 |
25,745 |
33,279 |
13,928 |
Working capital |
(9,600) |
(2,112) |
(1,722) |
(1,316) |
14,750 |
Land, buildings and machinery |
(39,000)
______ |
______ |
______ |
______ |
______ |
Cash flows (KRm) |
(48,600)
______ |
(1,966)
______ |
24,023
______ |
31,963
______ |
28,678
______ |
Year |
0
KRm |
1
KRm |
3
KRm |
4
KRm |
5
KRm |
Exchange rate |
101.4 |
120.1 |
133.7 |
142.5 |
151.9 |
Remittable flows |
(479,290) |
(16,370) |
179,678 |
224,302 |
188,795 |
Contribution (parts sales) ($120 + inflation per unit, W4) |
|
18,540 |
61,108 |
95,723 |
48,622 |
Royalty (W3) |
|
36,000 |
36,000 |
36,000 |
36,000 |
Tax on contribution and royalty (20%) |
|
(10,908) |
(19,422) |
(26,345) |
(16,924) |
Cash flows |
(479,290) |
27,262 |
257,364 |
329,680 |
256,493 |
Discount factors (12%) |
1 |
0.893 |
0.797 |
0.712 |
0.636 |
Present values |
(479,290) |
24,345 |
205,119 |
234,732 |
163,130 |
Net present value of the project before considering the impact of the lost contribution and redundancy is approximately $148.0 million.
Lost contribution and redundancy cost
The lost contribution and redundancy costs are small compared to the net present value and would therefore have a minimal impact of reducing the net present value by $0.1 million approximately.
(Note. Full credit will be given if the assumption is made that the amounts are in $'000 instead of $.)
Appendix 2
Workings
- Unit prices and costs including inflation
Year |
1 |
2 |
3 |
4 |
Selling price (€) |
735 |
772 |
803 |
835 |
Parts ($) |
288 |
297 |
306 |
315 |
Variable costs (KR) |
19,471 |
22,333 |
24,522 |
26,925 |
- Sales revenue and costs
Year |
1
KRm |
2
KRm |
3
KRm |
4
KRm |
Sales revenue |
150 × 735 ×165
= 18,191 |
480 ×772 × 180.2
= 66,775 |
730 × 803 ×190.2
= 111,493 |
360 × 835 × 200.8
= 60,360 |
Parts costs |
150 × 288 × 120.1
= 5,188 |
480 × 297 × 133.7
= 19,060 |
730 × 306 × 142.5
= 31,832 |
360 × 315 × 151.9
= 17,225 |
Variable costs |
150 × 19,471
= 2,921 |
480 × 22,333
= 10,720 |
730 × 24,522
= 17,901 |
360 × 26,925
= 9,693 |
- Royalty fee
$20 million x 1.8 = $36 million
This is then converted into YR at the KR/$ rate for each year: 120.1, 133.7, 142.5 and 151.9 for Years 1 to 4 respectively.
- Contribution from parts Year
Year |
1 |
2 |
3 |
4 |
Revenue per unit in $ |
280 × 1.03
= $288.4 |
288.4 × 1.03
= $297.052 |
297.052 × 1.03
= $305.964 |
305.964 × 1.03
= $315.143 |
Parts costs |
200 (current price) – 40 (contribution at current price) = $160
So, $160 × 1.03 = $164.8 |
$164.8 × 1.03
= $169.744 |
169.744 × 1.03
= $174.836 |
174.836 × 1.03
= $180.081 |
Contribution per unit |
288.4 – 164.8
= $123.6 |
297.052 – 169.744
= $127.308 |
305.964 – 174.836
= $131.128 |
315.143 – 180.081
= $135.062 |
Contribution in $m |
123.6 × 150m (volume)
= $18,540m |
127.308 × 480m
= $61,108m |
131.128 × 730m
= $95,723m |
135.062 × 360m
= $48,622m |
(Note. Credit will be given for alternative, relevant approaches to the calculations, and to the discussion of the assumptions, risks and issues.)
(21 marks)
(Professional marks for part (b) report 4 marks)