Question

A US based MNC is considering establishing a three-year project in Canada with a US$60 million initial investment. The required rate of return on this project is 15%. The firm is projected to generate operating cash flows of C$20 million in Years 1 and 2, and C$50 million in Year 3, and is expected to have a salvage value of C$30million.

The MNC must pay a 25% tax on remitted funds, and the stable exchange rate is C$1.02 per US$ over the next two years and a rate of C$1.025 per US$ in year 3.
All cash flows are remitted to the parent and there is no tax on salvage.
Required:
i) Calculate the after-tax operating cash flows that will be remitted to the parent
company each year.
ii) Calculate the Net Present Value of the project.
iii) Explain whether or not the MNC should accept the project?
iv) Flagstaff Corp. is a U.S.-based firm with a subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the next 10 years since the interest rate earned on these securities is so high. Then, after 10 years, it will remit all accu- mulated earnings to the United States. What is a drawback of using this ap- proach? (Assume the securities have no default or interest rate risk.).

Answer 1

i) The after-tax operating cash flows that will be remitted to the parent company each year are US$11,925,000 in Year 1, US$11,925,000 in Year 2, and US$29,812,500 in Year 3.
ii) The Net Present Value of the project is US$21,256,000.
iii) The MNC should accept the project because the Net Present Value is positive.
iv) A drawback of using this approach is that the exchange rate may fluctuate over the 10-year period, which could result in a lower or higher return on investment when the earnings are remitted to the United States.