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Global Financial Investment
 
A Note on Taxes
 
Because it is necessary to use after-tax cash flow in a capital budgeting analysis, international tax effects must be determined on any proposed foreign project before its NPV can be calculated. The tax laws on earnings remitted to a parent company vary among countries. Sometimes these laws allow tax deductions or credits for the multinational corporation (MNC) due to tax payments by subsidiaries to their host countries and sometimes they do not.
 
In the Wilson Company example below, three types of taxes affect cash flow — U.S. income taxes, Chinese income tax, and the withholding tax. U.S. income taxes are a flat 30% in the Wilson case. The foreign income of the subsidiary is not subject to U.S. taxes until funds are transferred to the U.S. parent in the form of dividends. When a dividend is remitted, U.S. tax law allows the MNC to credit income taxes paid in the foreign country against taxes owned by the parent.
 
For example, Wilson’s operations in China are subject to the Chinese income tax rate of 20% of pretax earnings. Since the Chinese subsidiary has paid Chinese income taxes lower than the 30% U.S. tax rate, the earnings remitted to the parent from the subsidiary will be subject to an additional amount of U.S. taxes to bring the total tax up to 30%. If the Chinese income tax is more than 30%, then Wilson does not need to pay any additional amount of U.S. tax. In fact, Wilson now has a tax credit: the excess foreign tax paid can be credited against other taxes owed by the parent, as long as they are due on the same type of income generated by overseas subsidiaries.
 
The second type of tax is a withholding tax. Dividends remitted by an MNC’s subsidiary are commonly subject to a withholding tax by the host government. Withholding taxes can vary substantially among countries and provide a way for the foreign government to tax MNCs that make dividend payments to non resident firms. The Wilson case mentions that there is a “risk that the Chinese government will impose a withholding tax of 10 percent on the profits that are sent to the U.S.” and further states that “additional tax credits will not be allowed, and Wilson will still be subject to a 10 percent U.S. tax on profits received from China.” Because the withholding tax is NOT considered an offset to U.S. income taxes in the Wilson case, Wilson is taxed on the difference between the 30% U.S. income tax and the 20% Chinese income tax rate.
 
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Wilson Company Example (rev 7/27/06)

 

The Wilson Company is a U.S. firm that is considering a joint venture with a Chinese firm to produce and sell videocassettes. Wilson will invest $12 million in this project, which will help to finance the Chinese firm’s production. For each of the first three years, 50 percent of the total profits will be distributed to the Chinese firm, while the remaining 50 percent will be converted to dollars to be sent to the U.S. The Chinese government intends to impose a 20 percent income tax on the profits distributed to Wilson. The Chinese government has guaranteed that the after-tax profits (denominated in renminbi, the Chinese currency) can be converted to U.S. dollars at an exchange rate of RM 1 = $.20 per unit and sent to Wilson Company each year. At the present time, there is no withholding tax imposed on profits to be sent to the U.S. as a result of joint ventures in China. Assume that even after considering the taxes paid in China, there is an additional 10 percent tax imposed by the U.S. government on profits received by Wilson Company. After the first three years, all profits earned are allocated to the Chinese firm.
 
The expected total profits resulting from the joint venture per year are as follows
 

Year	Total Profits from Joint Venture (in renminbi, RM)
1	RM 60 million
2	RM 80 million
3	RM 100 million

 
Wilson’s average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent. Assume that the corporate income tax rate imposed on Wilson is normally 30 percent. Wilson uses a capital structure composed of 60 percent debt and 40 percent equity. Wilson typically adds between 2 and 6 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. While this project has particular forms of country risk that are unique, Wilson plans to account for these forms of risk within its estimation of cash flows.
 
There are two forms of country risk that Wilson is concerned about. First, there is the risk that the Chinese government will increase the corporate income tax rate from 20 percent to 40 percent (20 percent probability). If this occurs, additional tax credits will be allowed, resulting in no U.S. taxes on the profits from this joint venture. Second, there is the risk that the Chinese government will impose a withholding tax of 10 percent on the profits that are sent to the U.S. (20 percent probability). In this case, additional tax credits will not be allowed, and Wilson will still be subject to a 10 percent U.S. tax on profits received from China. Assume that the two types of country risk are mutually exclusive. This is, the Chinese government will only adjust one of its tax guidelines (the income tax or the withholding tax), if any.
 

1. Determine Wilson’s cost of capital and its required rate of return for the joint venture in China.

 

To find the weighted average cost of capital, you multiply the cost of each source of capital by its weight in the total capital.  It tells you in the problem that “Wilson’s average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent.” Debt is 60% of the total capital and equity is 40%.
 
The 13.8% for debt is the before tax cost.  To get the after tax cost, you need ot multiply by (1-tax rate), so we get
 
13.8%  X  .7   =   9.66% for the after tax cost of debt.

The weighted average is 13% [ (.0966  x  .6) + (.18 x .4)  =  .1299 = .13]

Here’s another way to determine the cost of capital.
 
Wilson’s weighted average cost of capital is
 
K_c = D/(D+E)x K_d (1-T) + E/(D +E)K_e
K_c  = (60%) (13.8%) (70%) + (40%) (18%) = 5.8% + 7.2%  = 13%
 
Assume Wilson applies a premium of 4 percentage points to its cost of capital for this joint venture, its required rate of return on this joint venture would be 17 percent. Wilson also attempts to explicitly capture some types of country risk in the estimated cash flows, as explained shortly.
 

2. Determine the probability distribution of Wilson’s net present values for the joint venture.

 

Scenario 1:  Based on original assumptions
Scenario 2:  Based on an increase in the corporate income tax by the Chinese government.
Scenario 3:  Based on the imposition of a withholding tax by the Chinese government.
 
Scenario 1: Original Assumptions
 

	Year 0	Year 1	Year 2	Year 3
Total profits in CHY	0	60,000,000	80,000,000	100,000,000
Profits Allocated to Wilson Co.(50% of Total)	0	30,000,000	40,000,000	50,000,000
Corporate income taxes imposed by Chinese government (20%)	0	6,000,000	8,000,000	10,000,000
Profits to Wilson after paying corporate income taxes in China	0	24,000,000	32,000,000	40,000,000
Wilson’s dollar profits received from China (based on exchange rate of CHY 1 =$.20)	0	4,800,000	6,400,000	8,000,000
U.S. taxes paid (10%)	0	480,000	640,000	800,000
Cash flows from joint venture	0	4,320,000	5,760,000	7,200,000

 
The present value interest factor equals one divided by (1 + interest rate)number of years
 
Using a required rate of return of 17% for year one it is 0.85470, for year two it is 0.73051 and for year three 0.62437.
 

Year	Cash Flows	PV of Cash Flows
Year 0	0	0
Year 1	4,320,000	3,692,304
Year 2	5,760,000	4,207,738
Year 3	7,200,000	4,495,464
Total PV of Cash Flows		12,395,506

PV of Cash Flows: $12,395,506

Initial Investment: $12,000,000

Net Present Value = $12,395,506 – $12,000,000 = $395,000

Scenario 2: Increase in Income Tax

	Year 0	Year 1	Year 2	Year 3
Total profits in CHY	0	60,000,000	80,000,000	100,000,000
Profits Allocated to Wilson Co.(50% of Total)	0	30,000,000	40,000,000	50,000,000
Corporate income taxes imposed by Chinese government (40%)	0	12,000,000	16,000,000	20,000,000
Profits to Wilson after paying corporate income taxes in China	0	18,000,000	24,000,000	30,000,000
Wilson’s dollar profits received from China (based on exchange rate of CHY 1 =$.20)	0	3,600,000	4,800,000	6,000,000
U.S. taxes paid (0%)	0	0	0	0
Cash flows from joint venture	0	3,600,000	4,800,000	6,000,000

 
The present value interest factor equals one divided by (1 + interest rate)^{number of years}
 
Using a required rate of return of 17% for year one it is 0.85470, for year two it is 0.73051 and for year three 0.62437.
 

Year	Cash Flows	PV of Cash Flows
Year 0	0	0
Year 1	3,600,000	3,076,920
Year 2	4,800,000	3,506,448
Year 3	6,000,000	3,746,220
Total PV of Cash Flows		10,329,588

 
PV of Cash Flows: $10,329,588
 
Initial Investment: $12,000,000
 
Net Present Value = $10,329,588 – $12,000,000 = -$1,670,412

 
Scenario 3: Additional Withholding Tax
 

	Year 0	Year 1	Year 2	Year 3
Total profits in CHY	0	60,000,000	80,000,000	100,000,000
Profits Allocated to Wilson Co.(50% of Total)	0	30,000,000	40,000,000	50,000,000
Corporate income taxes imposed by Chinese government (20%)	0	6,000,000	8,000,000	10,000,000
Profits to Wilson after paying corporate income taxes in China	0	24,000,000	32,000,000	40,000,000
Withholding Tax at 10%		2,400,000	3,200,000	4,000,000
Profits to Wilson after Withholding Tax		21,600,000	28,800,000	36,000,000
Wilson’s dollar profits received from China (based on exchange rate of CHY 1 =$.20)	0	4,320,000	5,760,000	7,200,000
U.S. taxes paid (10%)	0	432,000	576,000	720,000
Cash flows from joint venture	0	3,888,000	5,184,000	6,480,000

 
The present value interest factor equals one divided by (1 + interest rate)^{number of years}
 
Using a required rate of return of 17% for year one it is 0.85470, for year two it is 0.73051 and for year three 0.62437.
 

Year	Cash Flows	PV of Cash Flows
Year 0	0	0
Year 1	3,888,000	3,323,073
Year 2	5,184,000	3,786,964
Year 3	6,480,000	4,045,918
Total PV of Cash Flows		11,155,955

 
PV of Cash Flows: $11,155,955
 
Initial Investment: $12,000,000
 
Net Present Value =  $11,155,955 – $12,000,000 = -$844,045
 
Summary of Scenarios
 

	A	B	A x B
Scenario	NPV	Probability	Expected NPV
Original	$395,000	60%	$237,000
Increase in Income Tax	-$1,670,412	20%	– $334,082
Increase in Withholding Tax	-$844,045	20%	– $168,809
Totals		100%	– $265,891

 
NOTE: The three possible scenarios above are mutually exclusive, as the Chinese government will either
 

1. Leave the tax situation unchanged, or
2. Increase its income tax, or
3. Increase the withholding tax.

 
The three possible scenarios are also collectively exhaustive because there are no other possible events.
 

Hence, the probability for no change to the original scenario must be 60%, because the percentages for mutually exclusive (and collectively exhaustive) events must add up to 100%.
 
Examples of mutually exclusive (and collectively exhaustive) events
 
Example 1: consider one toss of a fair coin.
 

• Probability of heads = 50%
• Probability of tails =  50%
• Sum of probabilities: 50% + 50% = 100%

 
Example 2: consider one roll of a fair die.
 
Possible outcomes are as follows: either 1, or 2, or 3, or 4, or 5, or 6.

Each possible outcome has a probability of 1/6 = 16.67%.

Sum of probabilities = 6 times 16.67% = 100%.
 
Conclusion: mutually exclusive (and collectively exhaustive) events must add up to 100%.
 

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

The total expected value of the NPV is negative $265,891. Thus, the project does not appear to be profitable for Wilson.
 

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

 
The key influential factor in this joint venture is probably the future economic conditions in China, which affects the demand for video cassettes, and therefore affects profits to be received. Since economic conditions in most countries (especially those that are not fully developed) are uncertain, there is much uncertainty about the profit estimates used in this example.
 

 
5. Under what circumstances might Wilson shift to more equity financing when considering joint ventures like this? What is the minimum required return that would still make this investment worthwhile?

 

Wilson might consider using more equity if it believes that the cash flows from joint ventures like this are very uncertain, in order to ensure that it maintains sufficient cash flows to cover its debt payments. This would drive up the required rate of return used in calculating the Net Present Values of each scenario and, in turn, decrease the Expected NPV.
 
The required return that would still make this investment worthwhile is the return that would make the Expected NPV equal to zero. Therefore, the required return would be exactly equal to the Internal Rate of Return for this project. If you calculated the IRR, it would be the return that would still make this investment worthwhile.
 

6. When Wilson was assessing this proposed joint venture, some of the managers in the company recommended that it borrow the Chinese currency rather than dollars to obtain some of the necessary capital for its initial investment. They suggested that such a strategy can reduce Wilson’s exchange rate risk. Do you agree? Explain.

 

This borrowing strategy is based upon the theory that if the renmimbi profit stream being repatriated to the U.S. were the same size as the payment stream on the renmimbi loan, then there would be no exchange rate risk because no currency is being converted. The loan denominated in Chinese currency could be paid back in Chinese currency. However, since the conversion of renmimbi to dollars was guaranteed by the Chinese government, there is no exchange rate risk because the exchange rate is known with certainty.
 
However, this conversion guarantee doesn’t eliminate inflation risk. If the agreed upon currency conversion rate doesn’t equate the changes in inflation in the U.S. to changes in inflation in China, there could be either a loss or gain in purchasing power when renmimbi are converted into dollars. Purchasing Power Parity says that when the international financial markets are in equilibrium, the exchange rate maintains parity in the purchasing power between the two currencies. In the Wilson case, the guaranteed exchange rate will cause inflation loss if dollar inflation is more than renmimbi inflation. On the other hand, if dollar inflation is less than that of the renmimbi, the fixed exchange rate will cause a gain in purchasing power when the renmimbi is converted into dollars. Therefore, borrowing in renmimbi would eliminate inflation risk if the profit and loan payment cash flows were the same. So it is recommended to borrow in renmimbi because this would reduce or eliminate inflation risk.
 
 
Global Investment case

 
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 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 patented process.

 

The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars Current .
exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at the 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 imp o sed by the US government on profits received by Gibson company.
 
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 %
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 driving 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 Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this jointventure.
 

(2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson 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 exchange .
 
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 would still make this investment worthwhile?
 

6. When Gibson was assessing this proposed joint venture, some of the managers in the company recommended that it borrow the Brazilian currency rather than using US dollars to obtain some of the necessary capital for the initial investment. They suggested that such a strategy could reduce Gibson’s exchange explain?
 

7. Discuss the benefits of the joint venture from the perspective of Brasilia. What is the maximum amount of money Brasilia should invest?
 
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