Question

Decision by Blades, Inc., to Invest in Thailand

Since Ben Holt, Blades’ chief financial officer (CFO), believes the growth potential for the roller blade market in Thailand is very high, he, together with Blades’ board of directors, has decided to invest in Thailand. The investment would involve establishing a subsidiary in Bangkok consisting of a manufacturing plant to pro- duce Speedos, Blades’ high-quality roller blades. Holt believes that economic conditions in Thailand will be relatively strong in 10 years, when he expects to sell the subsidiary.
Blades will continue exporting to the United King- dom under an existing agreement with Jogs, Ltd., a British retailer. Furthermore, it will continue its sales in the United States. Under an existing agreement with Entertainment Products, Inc., a Thai retailer, Blades is committed to selling 180,000 pairs of Speedos to the retailer at a fixed price of 4,594 Thai baht per pair. Once operations in Thailand commence, the agreement will last another year, at which time it may be renewed.
Thus, during its first year of operations in Thailand, Blades will sell 180,000 pairs of roller blades to Enter- tainment Products under the existing agreement whether it has operations in the country or not. If it establishes the plant in Thailand, Blades will produce 108,000 of the 180,000 Entertainment Products Speedos at the plant during the last year of the agree- ment. Therefore, the new subsidiary would need to import 72,000 pairs of Speedos from the United States so that it can accommodate its agreement with Enter- tainment Products. It will save the equivalent of 300 baht per pair in variable costs on the 108,000 pairs not previously manufactured in Thailand.
Entertainment Products has already declared its willingness to renew the agreement for another 3 years under identical terms. Because of recent delivery delays, however, it is willing to renew the agreement only if Blades has operations in Thailand. Moreover, if Blades has a subsidiary in Thailand, Entertainment
Holt wishes to analyze the financial feasibility of establishing a subsidiary in Thailand. As a Blades’ financial analyst, you have been given the task of ana- lyzing the proposed project. Since future economic conditions in Thailand are highly uncertain, Holt has also asked you to conduct some sensitivity analyses. Fortunately, he has provided most of the information you need to conduct a capital budgeting analysis. This information is detailed here:
-The building and equipment needed will cost 550 million Thai baht. This amount includes additional funds to support working capital.
-The plant and equipment, valued at 300 million baht, will be depreciated using straight-line depreciation. Thus, 30 million baht will be depreciated annually for 10 years.
-The variable costs needed to manufacture Speedos are estimated to be 3,500 baht per pair next year.
-Blades’ fixed operating expenses, such as administrative salaries, will be 25 million baht next year.
-The current spot exchange rate of the Thai baht is $.023. Blades expects the baht to depreciate by an average of 2 percent per year for the next 10 years.
-The Thai government will impose a 25 percent tax rate on income and a 10 percent withholding tax on any funds remitted by the subsidiary to Blades. Any earnings remitted to the United States will not be taxed again.
-After 10 years, Blades expects to sell its Thai subsidiary. It expects to sell the subsidiary for about 650 million baht, after considering any capital gains taxes.
-The average annual inflation in Thailand is expected to be 12 percent. Unless prices are contractually fixed, revenue, variable costs, and fixed costs are subject to inflation and are expected to change by the same annual rate as the inflation rate.
Blades could continue its current operations of exporting to and importing from Thailand, which have generated a return of about 20 percent. Blades requires a return of 25 percent on this project in order to justify its investment in Thailand. All excess funds generated by the Thai subsidiary will be remitted to Blades and will be used to support U.S. operations.
Holt has asked you to answer the following questions:
a. Should the sales and the associated costs of 180,000 pairs of roller blades to be sold in Thailand under the existing agreement be included in the capital budgeting analysis to decide whether Blades should establish a subsidiary in Thailand? Should the sales resulting from a renewed agreement be included? Why or why not?

Answer 1

a. Yes, the sales and associated costs of 180,000 pairs of roller blades to be sold in Thailand under the existing agreement should be included in the capital budgeting analysis. The sales resulting from a renewed agreement should also be considered. This is because these transactions represent cash flows directly related to the subsidiary's operations and are essential for evaluating the financial feasibility of establishing the subsidiary in Thailand.

Step-by-step explanation:

Including the sales and associated costs in the capital budgeting analysis is crucial for accurate decision-making. In capital budgeting, cash flows associated with the project are considered, and in this case, the sales of roller blades represent a significant revenue stream for Blades' subsidiary in Thailand. Including these cash flows provides a comprehensive picture of the financial impact of the subsidiary.

The cash inflows from selling roller blades under the existing and renewed agreements contribute to the subsidiary's revenue. The associated costs, including variable costs and potential savings from manufacturing in Thailand, directly affect the profitability of the subsidiary. By incorporating these figures, Blades can assess the net cash flows and determine whether the investment meets its required return of 25 percent.

In summary, the inclusion of sales and costs related to the roller blades in Thailand is essential for a thorough capital budgeting analysis. It ensures a comprehensive evaluation of the subsidiary's financial performance, aiding Blades in making an informed decision about investing in Thailand.