Benefits of own investment as opposed to licensing

Yung Co may be able to benefit from setting up its own plant as opposed to licensing in a number of ways.

First, Kendwe wants to attract foreign investment and is willing to offer a number of financial concessions to foreign investors which may not be available to local companies.

The company may also be able to control the quality of the components more easily, and offer better and targeted training facilities, if it has direct control of the labour resources.

The company may also be able to maintain the confidentiality of its products, whereas assigning the assembly rights to another company may allow that company to imitate the products more easily.

Investing internationally may provide opportunities for risk diversification, especially if Yung Co's shareholders are not well diversified internationally themselves.

Finally, direct investment may provide Yung Co with new opportunities in the future, such as follow-on options.

Drawbacks of own investment as opposed to licensing

Direct investment in a new plant will probably require higher, upfront costs from Yung Co compared to licensing the assembly rights to a local manufacturer. It may be able to utilise these saved costs on other projects.

Yung Co will most likely be exposed to higher risks involved with international investment, such as political risks, cultural risks and legal risks. With licensing these risks may be reduced somewhat.

The licensee, because it would be a local company, may understand the operational systems of doing business in Kendwe better. It will therefore be able to get off the ground quicker. Yung Co, on the other hand, will need to become familiar with the local systems and culture, which may take time and make it less efficient initially.

Similarly, investing directly in Kendwe may mean that it costs Yung Co more to train the staff and possibly require a steeper learning curve from them. However, the scenario does say that the country has a motivated and well-educated labour force and this may mitigate this issue somewhat.

(Note. Credit will be given for alternative, relevant suggestions.)

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

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

1. Unit prices and costs including inflation

2. Sales revenue and costs

3. 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.

4. Contribution from parts Year

(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)

All figures are in $ million

Base case net present value is approximately $8.62 million.

• All figures are in $ million

• All figures are in $ million

Flint Co asset beta = 1.5 × $128m/ ($128m + $31.96m × 0.8) approx. = 1.25

All-equity financed discount rate = 2% + 1.25 × 8% = 12%

Financing side effects

Financing the project entirely by debt would add just under $1.78 million to the value of the project, or approximately, an additional 20% to the all-equity financed project.

The adjusted present value (APV) of the project is just under $10.4 million and therefore it should be accepted.

Examiner’s note:  In calculating the present values of the tax shield and subsidy benefits, the annuity factor used is based on 4% to reflect the normal borrowing/default risk of the company.

Alternatively, 2% or 2.5% could be used depending on the assumptions made. Credit will be given where these are used to estimate the annuity factor, where the assumption is explained.

Corrections made to the original net present value

The approach taken to exclude depreciation from the net present value computation is correct, but tax allowable depreciation needs to be taken away from profit estimates before tax is calculated, reducing the profits on which tax is payable.

Interest is not normally included in the net present value calculations. Instead, it is normally imputed within the cost of capital or discount rate. In this case, it is included in the financing side effects.

Cash flows are inflated and the nominal rate based on Flint Co’s all-equity financed rate is used (see below). Where different cash flows are subject to different rates of inflation, applying a real rate to non-inflated amounts would not give an accurate answer.

The impact of the working capital requirement is included in the estimate as, although all the working capital is recovered at the end of the project, the flows of working capital are subject to different discount rates when their present values are calculated.

Approach taken

The value of the project is initially assessed considering only the business risk involved in undertaking the project. The discount rate used is based on Flint Co’s asset beta which measures only the business risk of that company. Since Flint Co is in the same line of business as the project, it is deemed appropriate to use its discount rate, instead of 11% which Brown Co uses normally.

The impact of debt financing and the subsidy benefit are then considered. In this way, Brown Co can assess the value created from its investment activity and then the additional value created from the manner in which the project is financed.

Assumptions made

It is assumed that all figures used are accurate and any estimates made are reasonable. Brown Co may want to consider undertaking a sensitivity analysis to assess this.

It is assumed that the initial working capital required will form part of the funds borrowed but that the subsequent working capital requirements will be available from the funds generated by the project. The validity of this assumption needs to be assessed since the working capital requirements at the start of years 2 and 3 are substantial.

It is assumed that Flint Co’s asset beta and all-equity financed discount rate represent the business risk of the project. The validity of this assumption also needs to be assessed. For example, Flint Co’s entire business may not be similar to the project, and it may undertake other lines of business. In this case, the asset beta would need to be adjusted so that just the project’s business risk is considered.

(Note: Credit will be given for alternative, relevant explanations)

Base case net present value is approximately ($5.09 million) and on this basis, the investment should be rejected.

Workings

1. Working capital

2. Discount rate

Using asset beta

All-equity financed discount rate = 4% + (11% – 4%) 1.14 = 12%

3. Issue costs

$80 million/0·97 = $82,474,227

Issue costs = 3% x $82,474,227 = $2,474,227

There will be no issue costs for the bank loan.

4. Tax shield on subsidised loan

Use PV of an annuity (PVA) years 1 to 4 at 8% (normal borrowing rate)

$80m u 0·031 x 30% x 3.312 = $2,464,128

Note: Full credit should be given if tax shield is discounted at the government interest rate of 3·1% rather than the normal borrowing rate of 8%.

5. Tax shield on bank loan

Annual repayment = ($70m/PVA 8% Yr 1 – 4) = ($70m/3.312) = $21,135,266

6. Subsidy benefit

Benefit = $80m x (0.08 – 0.031) x 70% x 3.312 = $9,088,128 7

7. Financing side effects

Financing the project in this way would add around $12.82 million to the value of the project.

The adjusted present value of the project is around $7.73 million and so the project should be accepted. Sensitivity analysis should be undertaken on all the significant variables. Further analysis may be needed, particularly of the assumptions which lie behind the post-tax cash flows, such as sales and the tax rate. The realisable value of $45 million may be questionable. On the other hand, the time horizon of four years seems low and analysis should be done of potential cash flows beyond that time.

Amber Co's board can use various principles to determine its long-term finance mix. The directors may aim to follow consistent long-term policies, or they may have preferences which change as circumstances change.

Long-term policy factors

At present Amber Co is using a mix of finance, raising the question of whether the directors are aiming for an optimal level of gearing, or there is a level which they do not wish gearing to exceed. If the board wishes to maintain gearing at an optimal level, this is likely to be determined by a balance of risks and advantages. The main risks are not being able to maintain the required level of payment to finance providers, interest to debt providers or required level of dividend to shareholders. Advantages may include lower costs of debt, tax relief on finance costs as shown in the APV calculation or, on the other hand, not being legally required to pay dividends in a particular year.

Another issue is whether Amber Co's board has preferences about what source of finance should be used and in what order. One example of this is following the pecking order of retained earnings, then debt, then equity. The board may prefer this pecking order on the grounds that avoiding a new equity issue means that the composition of shareholdings is unchanged, or because retained earnings and longer-term debt are judged low risk, or because the market will assume that an equity issue is being made because directors want to take advantage of Amber Co's shares being over-priced. Other specific sources of finance may have benefits which attract the directors or drawbacks which deter them.

This investment highlights the aspect of whether the board prefers to match sources of finance with specific investments. Matching arguably gives greater flexibility and avoids committing Amber Co to a long-term interest burden. However, to adopt this approach, the board will need assurance either that the investment will be able to meet finance costs and ultimately repayment burdens, or these can be met from surpluses from other operations.

Changing long-term financing policy

As well as deciding what financing mix or sources of finance they desire to use, the directors will also need to consider what factors would cause this decision to change.

A major change in the scope of the operations, with investment requirements being paramount, may cause a change in financing policy. Here the $150 million investment has been financed entirely by medium-term debt. Amber Co may have chosen solely to use debt if it has made a recent equity issue and does not feel it can make another one so soon afterwards. In addition, if Amber Co expands its manufacture of electric cars, it may decide to sell off its motorbike or cycles divisions if they are performing less well. If part of the business is sold, the sale proceeds could help finance new investment in the cars division.

The board may also be flexible at times and take advantage of whatever source of finance seems to be offering the best terms for Amber Co. Here the board is taking advantage of loan finance being available at a low cost, thanks to the government loan scheme.

A change in the business or economic environment may also lead to the board rethinking how the company is financed. An economic recession, leading to falling share prices, may mean that the results of a share issue are uncertain. On the other hand, an increase in economic or business risk may mean that lenders are less likely to lend at acceptable rates or will impose greater restrictions. If the directors are risk-averse, they may not seek new finance during a recession but instead rely on retained earnings to finance any expansion.