BilT is an Australian company that produces body care products. Founded in 1965, the company has grown from a small family business, to a medium-sized corporation with around 500 employees and more than 100 stores spread all over Australia. The company is contemplating establishing a subsidiary in Argentina, the first step to becoming a leading brand in South America. The subsidiary will initially operate for a period of 5 years, with a decision by BilT of whether or not to carry on with the foreign business, to be made later on during the project’s lifetime. BilT’s required rate of return is 10%, and the development of the subsidiary requires an initial investment of AR$40 million: 50% is to be allocated to the construction of facilities, 40% to the purchase of machines, and 10% to working capital.
At this stage, the only product to be marketed in Argentina will be BilT’s flagship brand overTHEsun — a sunscreen that the company expects to sell at a price of AR$120 per unit (to be adjusted annually according to the inflation rate, forecasted at 10% per year), with an estimated demand of 200,000 units per year (i.e. assumed to be stable during the project’s lifetime). The variable costs associated with the production of the sunscreen are mainly due to labor and materials, amounting to AR$50 per unit, with fixed costs being mainly overhead expenses of AR$800,000 per year. The only factor causing future changes in both variable and fixed costs is the inflation rate. Tax laws in Argentina allow for the total cost of facilities and machines to be fully depreciated (zero book value) by the end of 5 years, in
amounts equally spread across the project’s lifetime. Although the machines to be employed in the production of the sunscreen will have zero salvage value, at the end of the project the facilities built can be sold at an estimated price of AR$22 million (i.e. the commercial real estate sector is booming in Argentina, with no signs of waning in the foreseeable future). Also, although Argentina imposes a corporate tax rate of 35% on income, there are neither capital gain taxes nor restrictions or taxes on funds to be sent to BilT in Australia.
Based on the above information, write a report addressing the following:
a) Presenting your calculations in a table format, indicate the annual cash flows in ARS that the subsidiary of BilT expects to remit to Australia during the project’s lifetime.
b) The spot rate of Argentine pesos is being quoted at AUD 0.10, the same that the company expects to prevail in the next 5 years (i.e. before accounting for inflation). Moreover, the forward rate is currently quoted at AUD 0.10 for years 1 and 2, AUD 0.08 for years 3 and 4, and AUD 0.07 for year 5. Calculate the annual cash flows (in USD) that BilT will receive if: (i) its subsidiary hedges AR$10 million annually during the project’s lifetime, and (ii) no revenue is hedged. What is the net present value (NPV) associated with the investment in the subsidiary following the hedging and nonhedging strategies? Which one would you suggest to use?
c) BilT is contemplating a different financial arrangement in order to establish its subsidiary in Argentina. In particular, the company wants to use its own funds to finance 40% of the initial investment, with the remaining 60% to be obtained by issuing debt. The question is whether the company should issue the debt in Australia or rather in Argentina; in the former, BilT could borrow at an annual rate of 6%, whereas in the later, at a rate of 12% (both loans involve annual payments from years 1 to 5, plus a principal payment in year 5). What would be the best option for BilT, i.e. the one that would maximize the NPV of the project?
d) Another option for BilT would be to issue new shares in order to finance the investment in the Argentine subsidiary. Based on the capital asset pricing model (CAPM), provide an estimate of the cost of equity if shares were issued in Australia, and similarly, if shares were issued in Argentina. Elaborate on the factors driving the difference between the two.
e) Before approving the project, the board of directors at BilT asks what the consequences for its subsidiary would be, in case halfway through the project (e.g. year 3) the world finds itself engulfed in a crisis of the magnitude of the GFC of 2007– 2009. Answer the question raised by the board by explaining how you expect the demand for sunscreens in Argentina and the exchange rate ARS/AUD to be affected, and how a potential shortage of funds at the subsidiary could be overcome.