QUESTION 10: CLIPTON CO
Clipton Co is a listed company that is based in the USA and manufactures electronic devices. One of its devices, the X-IT, is produced exclusively for the American market. Clipton Co is considering ceasing the production of the X-IT gradually over a period of four years because it needs the manufacturing facilities used to make the X-IT for other products.
The government of Brunei, a country based in south-east Asia, is keen to develop its manufacturing industry and has offered Clipton Co first rights to produce the X-IT in Brunei and sell it to the USA market for a period of four years. At the end of the four-year period, the full production rights will be sold to a government backed company for Brunein Dollar (BND) 450 million after tax (this amount is not subject to inflationary increases). Clipton Co has to decide whether to continue production of the X-IT in the USA for the next four years or to move the production to Brunei immediately.
Currently each X-IT unit sold makes a unit contribution of $20. This unit contribution is not expected to be subject to any inflationary increase in the next four years. Next year’s production and sales estimated at 40,000 units will fall by 20% each year for the following three years. It is anticipated that after four years the production of X-IT will stop. It is expected that the financial impact of the gradual closure over the four years will be cost neutral (the revenue from sale of assets will equal the closure costs). If production is stopped immediately, the excess assets would be sold for $2.3 million and the costs of closure, including redundancy costs of excess labour, would be $1.7 million.
The following information relates to the production of the X-IT moving to Brunei. The Brunein project will require an initial investment of BND 230 million, to pay for the cost of land and buildings (BND 150 million) and machinery (BND 80 million). The cost of machinery is tax allowable and will be depreciated on a straight-line basis over the next four years, at the end of which it will have a negligible value.
Clipton Co will also need BND 40 million for working capital immediately. It is expected that the working capital requirement will increase in line with the annual inflation rate in Brunei. When the project is sold, the working capital will not form part of the sale price and will be released back to Clipton Co.
Production and sales of the device are expected to be 12,000 units in the first year, rising to 22,000 units, 47,000 units and 60,000 units in the next three years respectively.
The following revenues and costs apply to the first year of operation:
- Each unit will be sold for $7
- The variable cost per unit comprising of locally sourced materials and labour will be BND 1,350, and
- In addition to the variable cost above, each unit will require a component bought from Clipton Co for $7, on which Clipton Co makes $4 contribution per unit
- Total fixed costs for the first year will be BND 30 million.
The costs are expected to increase by their countries’ respective rates of inflation, but the selling price will remain fixed at $70 per unit for the four-year period.
The annual corporation tax rate in Brunei is 20% and Clipton Co currently pays corporation tax at a rate of 30% per year. Both countries’ corporation taxes are payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the USA and Brunei, which permits offset of overseas tax against any US tax liability on overseas earnings. The USA and Brunein tax authorities allow losses to be carried forward and written off against future profits for taxation purposes.
Clipton Co has decided to finance the project by borrowing the funds required in Brunei. The commercial borrowing rate is 13% but the Brunein government has offered Clipton Co a 6% subsidised loan for the entire amount of the initial funds required. The Brunein government has agreed that it will not ask for the loan to be repaid as long as Clipton Co fulfils its contract to undertake the project for the four years. Clipton Co can borrow dollar funds at an interest rate of 5%.
Clipton Co’s financing consists of 25 million shares currently trading at $2.40 each and $40 million 7% bonds trading at $1,428 per $1,000. Clipton Co’s quoted beta is 1.17. The current risk-free rate of return is estimated at 3% and the market risk premium is 6%. Due to the nature of the project, it is estimated that the beta applicable to the project if it is all-equity financed will be 0.4 more than the current all-equity financed beta of Clipton Co. If the Brunein project is undertaken, the cost of capital applicable to the cash flows in the USA is expected to be 7%.
The spot exchange rate between the dollar and the Brunein Rupiah is BND 55 per $1. The annual inflation rates are currently 3% in the USA and 9% in Brunei. It can be assumed that these inflation rates will not change for the foreseeable future. All net cash flows arising from the project will be remitted back to Clipton Co at the end of each year.
There are two main political parties in Brunei: The Brunei Liberal (BL) Party and the Brunei Republican (BR) Party. Brunei is currently governed by the BL Party but general elections are due to be held soon. If the BR Party wins the election, it promises to increase taxes of international companies operating in Brunei and review any commercial benefits given to these businesses by the previous government.
Required:
a. Prepare a report for the Board of Directors (BoD) of Clipton Co that
i. Evaluates whether or not Clipton Co should undertake the project to produce the X-IT in Brunei and cease its production in the USA immediately. In the evaluation, include all relevant calculations in the form of a financial assessment and explain any assumptions made.
It is suggested that the financial assessment should be based on present value of the operating cash flows from the Brunein project, discounted by an appropriate all-equity rate, and adjusted by the present value of all other relevant cash flows.
(27 marks)
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b. Discusses the potential change in government and other business factors that Clipton Co should consider before making a final decision.
(8 marks)
Professional marks for format, structure and presentation of the report for part (a).
(4 marks)
REPORT TO THE BOARD OF DIRECTORS, CLIPTON CO
EVALUATION OF WHETHER THE PRODUCTION OF X-IT SHOULD MOVE TO BRUNEI
This report evaluates the possibility of moving the production of the X-IT to Brunei from the USA. Following the initial evaluation, the report discusses the key assumptions made, the possible impact of a change in the government in Brunei after the elections due to take place shortly and other business factors that should be considered before a final decision is made.
Initially a base case net present value calculation is conducted to assess the impact of the production in Brunei. This is then adjusted to show the impact of cash flows in the USA as a result of the move, the immediate impact of ceasing production and the impact of the subsidy and the tax shield benefits from the loan borrowing.
Based on the calculations presented in the appendix, the move will result in a positive adjusted present value of just over $2.4 million. On this basis, the initial recommendation is that the production of X-IT should cease in the USA and the production moved to Brunei instead.
Assumptions
It is assumed that the borrowing rate of 5% is used to calculate the benefits from the tax shield. It could be argued that the risk-free rate of 3% could be used as the discount rate instead of 5% to calculate the present value of benefits from the tax shields and the subsidies.
In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used.
It has been assumed that many of the input variables, such as for example the tax and tax allowable depreciation rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate and will change as stated over the four-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would appropriate for Clipton Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions.
Government change
From the facts of the case, it would seem that a change of government could have a significant impact on whether or not the project is beneficial to Clipton Co. The threat to raise taxes may not be too significant as the tax rates would need to increase to more than 30% before Clipton Co would lose money. However, the threat by the opposition party to review ‘commercial benefits’ may be more significant.
Just over 40% of the present value comes from the tax shield and subsidy benefits. If these were reneged then Clipton Co would lose a significant of the value attached to the project. Also, the new government may not allow remittances every year, as is assumed in part (i). However, this may not be significant since the largest present value amount comes from the final year of operation.
Other business factors
Clipton Co should consider the possibility of becoming established in Brunei, and this may lead to follow-on projects. The real options linked to this should be included in the analysis.
Clipton Co’s overall corporate strategy should be considered. Does the project fit within this strategy? Even if the decision is made to close the operation in the USA, there may be other alternatives and these need to be assessed.
The amount of experience Clipton Co has in international ventures needs to be considered. For example, will it be able to match its systems to the Brunein culture? It will need to develop strategies to deal with cultural differences. This may include additional costs such as training which may not have been taken into account.
Clipton Co needs to consider if the project can be delayed at all. From part (i), it can be seen that a large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the commencement of the project may increase the overall value of the project.
Clipton Co needs to consider the impact on its reputation due to possible redundancies. Since the production of X-IT is probably going to be stopped in any case, Clipton Co needs to communicate its strategy to the employees and possibly other stakeholders clearly so as to retain its reputation. This may make the need to consider alternatives even more important.
Conclusion
Following from a detailed sensitivity analysis, analysis of a possible change in the government and an evaluation of the financial benefits accruing from the other business factors discussed above, the BoD can make a decision of whether to move the production to Brunei or not. This initial evaluation suggests that moving the production of the X-IT to Brunei would be beneficial.
Appendix
Brunein Project Operating Cash Flows
(All amounts in BND/$000s)
Year |
Now |
1 |
2 |
3 |
4 |
Sales revenue (w2) |
 |
48,888 |
94,849 |
214,442 |
289,716 |
Local variable costs (w3) |
 |
(16,200) |
(32,373) |
(75,385) |
(104,897) |
Imported component (w4) |
 |
(4,889) |
(9,769) |
(22,750) |
(31,658) |
Fixed costs |
 |
(30,000) |
(32,700) |
(35,643) |
(38,851) |
Profits before tax |
 |
(2,201) |
20,007 |
80,664 |
114,310 |
Taxation (w5) |
 |
0 |
0 |
(7,694) |
(18,862) |
Investment |
(230,000) |
 |
 |
 |
450,000 |
Working capital |
(40,000) |
(3,600) |
(3,924) |
(4,277) |
51,801 |
Cash flows (BND) |
(270,000) |
(5,801) |
16,083 |
68,693 |
597,249 |
Exchange rate (w1) |
55.00 |
58.20 |
61.59 |
65.18 |
68.98 |
Cash flows ($) |
(4,909) |
(100) |
261 |
1,054 |
8,658 |
Discount factor for 9.6% (w6)
(Full credit given if 10% is used as the discount rate) |
 |
0.912 |
0.832 |
0.760 |
0.693 |
Present values ($) |
(4,909) |
(91) |
217 |
801 |
6,000 |
Net present value (NPV) of the cash flows from the project is approx. $2,018,000.
Adjusted present value (APV) |
$000 |
NPV of cash flows |
2,018 |
Additional USA tax, opportunity cost (revenues foregone from current operations) and additional contribution from component exported to project (net of tax) (w7) |
(1,237) |
Closure revenues and costs ($2,300,000 – $1,700,000) |
600 |
Tax shield and benefit of subsidy (w8) |
1,033 |
Total APV |
2,414 |
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Workings:
(W1) Exchange rates
Year |
1 |
2 |
3 |
4 |
BND/$1 |
55 × 1.09/1.03 = 58.20 |
58.20 × 1.09/ 1.03 = 61.59 |
61.59 × 1.09/ 1.03 = 65.18 |
65.18 × 1.09/ 1.03 = 68.98 |
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(W2) Sales revenue (BND 000s)
Year |
1 |
2 |
3 |
4 |
Price × units × exchange rate |
70 × 12,000 × 58.20 = 48,888 |
70 × 22,000 × 61.59 = 94,849 |
70 × 47,000 × 65.18 = 214,442 |
70 × 60,000 × 68.98 = 289,716 |
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(W3) Local variable costs (BND 000s)
Year |
1 |
2 |
3 |
4 |
Cost × units × inflation after year 1 |
1,350 × 12,000 = 16,200 |
1,350 × 22,000 × 1.09 = 32,373 |
1,350 × 47,000 × 1.092 = 75,385 |
1,350 × 60,000 × 1.093 = 104,897 |
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(W4) Imported component (BND 000s)
Year |
1 |
2 |
3 |
4 |
Price × units × inflation after year 1 × exchange rate |
7 × 12,000 × 58.20 = 4,889 |
7 × 22,000 × 1.03 × 61.59 = 9,769 |
7 × 47,000 × 1.032 × 65.18 = 22,750 |
70 × 60,000 × 1.033 × 68.98 = 31,658 |
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(W5) Local variable costs (BND 000s)
Year |
1 |
2 |
3 |
5 |
Profits before tax |
(2,201) |
20,007 |
80,664 |
114,310 |
Tax allowable depreciation |
(20,000) |
(20,000) |
(20,000) |
(20,000) |
Profit/(loss) after depreciation |
(22,201) |
7 |
60,664 |
94,310 |
Taxable profits |
0 |
0 |
38,470 |
94,310 |
Taxation (20%) |
0 |
0 |
(7,694) |
(18,862) |
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(W6) Brunei project all-equity financed discount
Clipton Co equity beta = 1.17
MVe = $2.40 × 25m shares = $60m
MVd = $40m × $1,428/$1,000 = $57.12m
Clipton Co asset beta (assuming debt is rate risk free)
1.17 × 60m/ (60m + 57.12m × 0.7) = 0.70
Project asset beta = 0.70 + 0.40 = 1.10
Project all-equity financed discount rate = 3% + 6% × 1.1 = 9.6%
(W7) Additional tax, additional contribution and opportunity cost ($000s)
Year |
1 |
2 |
3 |
4 |
Additional tax Taxable profits × 1/exchange rate × 10% |
0 |
0 |
38,470 × 1/65.18 × 10% = (59) |
94,310 × 1/68.98 × 10% = (137) |
Opportunity cost |
|
|
|
|
Units × contribution × (1 – tax) |
40 × $20 × 0.7 = (560) |
32 × $20 × 0.7 = (448) |
25.6 × $20 × 0.7 = (358) |
20.48 × $20 × 0.7 = (287) |
Additional Contribution |
|
|
|
|
Units × contribution × inflation × (1 – tax) |
12 × $4 × 0.7 = 34 |
22 × $4 × 1.03 × 0.7 = 63 |
47× $4 × 1.032 × 0.7= 140 |
60 × $4 × 1.033 × 0.7 = 184 |
Total cash flows |
(526) |
(385) |
(277) |
(240) |
PV of cash flows Discount at 7% |
(492) |
(336) |
(226) |
(183) |
NPV is approx. $(1,237,000) |
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(W8) Tax shield and subsidy benefits ($/BND 000s)
Year |
1 |
2 |
3 |
4 |
Interest × loan × tax rate |
6% × 270m × 20% = 3,240 |
3,240 |
3,240 |
3,240 |
Annual subsidy benefit (BND) |
 |
 |
 |
 |
Interest gain × loan × (1 – tax rate) |
7% × 270m × 0.8 = 15,120 |
15,120 |
15,120 |
15,120 |
Total tax shield + subsidy benefits (BND) |
18,360 |
18,360 |
18,360 |
18,360 |
Exchange rate (BND/$1) |
58.20 |
61.59 |
65.18 |
68.98 |
Cash flows ($) |
315 |
298 |
282 |
266 |
PV of cash flows Discount at 5% |
300 |
270 |
244 |
219 |
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NPV of tax shield and subsidy benefit is approx. $1,033,000
(35 marks)
(Professional marks for part (a) 4 marks)