SECTION F- 50-mark questions
QUESTION 01- NAHARA CO
Since becoming independent just over 20 years ago, the country of Khaza has adopted protectionist measures which have made it difficult for multinational companies to trade there. However, recently, after discussions with the World Trade Organization (WTO), it seems likely that Khaza will reduce its protectionist measures significantly.
Encouraged by these discussions, Nahara Co, a company producing packaged foods, is considering a project to set up a manufacturing base in Khaza to sell its goods there and in other regional countries nearby. An initial investigation costing $500,000 established that Khaza had appropriate manufacturing facilities, adequate transport links and a reasonably skilled but cheap workforce. The investigation concluded that, if the protectionist measures were reduced, then the demand potential for Nahara Co’s products looked promising. It is also felt that an early entry into Khaza would give Nahara Co an advantage over its competitors for a period of five years, after which the current project will cease, due to the development of new advanced manufacturing processes.
Khaza’s currency, the Peso (KP), is currently trading at KP72 per $1. Setting up the manufacturing base in Khaza will require an initial investment of KP2,500 million immediately, to cover the cost of land and buildings (KP1,250 million) and machinery (KP1,250 million). Tax-allowable depreciation is available on the machinery at an annual rate of 10% on cost on a straight-line basis. A balancing adjustment will be required at the end of year five, when it is expected that the machinery will be sold for KP500 million (after inflation). The market value of the land and buildings in 5 years’ time is estimated to be 80% of the current value. These amounts are inclusive of any tax impact.
Nahara Co will require KP200 million for working capital immediately. It is not expected that any further injections of working capital will be required for the five years. When the project ceases at the end of the fifth year, the working capital will be released back to Nahara Co.
Production of the packaged foods will take place in batches of product mixes. These batches will then be sold to supermarket chains, wholesalers and distributors in Khaza and its neighbouring countries, which will repackage them to their individual requirements. All sales will be in KP. The estimated average number of batches produced and sold each year is given below:
|Batches produced and sold
The current selling price for each batch is estimated to be KP115,200. The costs related to producing and selling each batch are currently estimated to be KP46,500. In addition to these costs, a number of products will need a special packaging material which Nahara Co will send to Khaza. Currently the cost of the special packaging material is $200 per batch. Training and development costs, related to the production of the batches, are estimated to be 80% of the production and selling costs (excluding the cost of the special packaging) in the first year, before falling to 20% of these costs (excluding the cost of the special packaging) in the second year, and then nil for the remaining years. It is expected that the costs relating to the production and sale of each batch will increase annually by 10% but the selling price and the special packaging costs will only increase by 5% every year.
The current annual corporation tax rate in Khaza is 25% and Nahara Co pays annual corporation tax at a rate of 20% in the country where it is based. Both countries’ taxes are payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the two countries which permits offset of overseas tax against any tax liabilities Nahara Co incurs on overseas earnings.
The risk-adjusted cost of capital applicable to the project on $-based cash flows is 12%, which is considerably higher than the return on short-dated $ treasury bills of 4%. The current rate of inflation in Khaza is 8%, and in the country where Nahara Co is based it is 2%. It can be assumed that these inflation rates will not change for the foreseeable future. All net cash flows from the project will be remitted back to Nahara Co at the end of each year.
Nahara Co’s Finance Director is of the opinion that there are many uncertainties surrounding the project and has assessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties.
Recently Tahi Co offered Nahara Co the option to sell the entire project to Tahi Co for $28 million at the start of year three. Nahara Co will make the decision of whether or not to sell the project at the end of year two.
a. Discuss the role of the World Trade Organization (WTO) and the possible benefits and drawbacks to Khaza of reducing protectionist measures.