Case Study-AW-Q171

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The Gibson Company is a United States (US) firm that is considering a joint venture with Brasilia, DF, a Brazilian firm that grows and processes coffee beans. Gibson has a patent for a new coffee processing method. This intellectual property is motivating Gibson to expand beyond importing coffee to engaging in a joint venture to process the coffee. Gibson will invest $8 million in the proposed joint venture project, which will help to finance Brasilia ‘s production using the newly patented process.
 

The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.
 
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The expected total profits resulting from the joint venture per year are as follows
 

Year Total Profits from Joint Venture (in BRL)
1 40 million
2 60 million
3 70 million
4 90 million
5 120 million
 

Gibson’s average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibson’s US income tax rate is 10 percent.
Gibson’s capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates.
 

Gibson is concerned about country risk in the following two forms
 

(1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs,
Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this joint venture.
 

(2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson (20 percent probability)? If this occurs, Gibson will not receive additional tax credits, and the company will still be subject to US tax on the profits from this joint venture.
 

Assume that the two types of country risk are mutually exclusive. If it does anything, the Brazilian government will only implement one of these changes in its tax policies
(i.e., the increase in the basic income tax on the profits of the joint venture or the additional income tax on profits distributed to foreign companies). The Brazilian government may also choose to leave things as they are.
 

Assignment
 

1. Determine Gibson’s cost of capital and required rate of return for the joint venture in Brazil.

2. Determine the discrete probability distribution of Gibson’s Net Present Value for this joint venture and calculate the Expected Net Present Value.

3. Would you recommend that Gibson participate in the joint venture? Explain.

4. What do you think would be the key underlying factor that would have the most influence on the profits earned in Brazil as a result of the joint venture?

5. Under what circumstances might Gibson shift to more equity financing when considering joint ventures like this? What is the minimum required return that
 

Breakeven Analysis
 

Breakeven analysis is a tool used to determine the level of sales needed to balance costs and revenues. This tool can also be used to determine the level of sales needed to reach a specific profit (target profit).
Conversely, this tool may determine the selling price needed to achieve a specific profit given the level of demand (target return pricing).

Finally, this tool provides an analysis of how sensitive the profit is to variations in sales (sensitivity analysis).
 

Breakeven Analysis

Example

Widgets, Inc. Per Unit 1,000 units

Sales $25.00 $25,000
Variable Manufacturing Costs $15.00 $15,000 Variable costs are costs that increase as volume increases, such as raw materials and direct labor.
Fixed Manufacturing Costs $5,000 Fixed costs are costs that do not increase with volume, such as factory rent, depreciation and insurance.
Total Manufacturing Costs $20.00 $20,000
Contribution Margin $10.00 $10,000 Contribution margin is Sales less Variable Costs
Gross Profit $5.00 $5,000 Gross Profit is Sales less Total Manufacturing Costs
Selling, General & Administrative Costs $2,000 These are non-manufacturing costs, which are usually fixed
Income before Taxes $3,000
 

Breakeven Formula: Breakeven Quantity = Total Fixed Costs = $5,000+ $2,000 = 700 units
Unit Contribution Margin $10.00
 

# Units Sales Variable Manufacturing Costs Fixed Costs Total Costs Income before Taxes
0 0 0 $7,000 $7,000 -$7,000
100 $2,500 $1,500 $7,000 $8,500 -$6,000
200 $5,000 $3,000 $7,000 $10,000 -$5,000
300 $7,500 $4,500 $7,000 $11,500 -$4,000
400 $10,000 $6,000 $7,000 $13,000 -$3,000
500 $12,500 $7,500 $7,000 $14,500 -$2,000
600 $15,000 $9,000 $7,000 $16,000 -$1,000
700 $17,500 $10,500 $7,000 $17,500 $0 Breakeven
800 $20,000 $12,000 $7,000 $19,000 $1,000
900 $22,500 $13,500 $7,000 $20,500 $2,000
1,000 $25,000 $15,000 $7,000 $22,000 $3,000
Problem Assignments: Week 8

Assigned Problems Points
1

 

1-A What is the contribution margin of the product? 2 points 2
Answer: $4.50
 

1-B Calculate the breakeven point in unit sales and dollars.
 

Answer: Breakeven in units is 11,112 3 points 2
Answer: Breakeven in dollars is $83,340.00 3 points 2
Why is the answer not 11,111.111 units? 2
 

1-C What is the operating profit (loss) at 5,000 units per year?
Answer: -$27,500.00 Loss 3 points 2
 

1-D What is the operating profit (loss) at 15,000 units per year?
Answer: $17,500.00 3 points 2
 
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