Question 3

Gulf company is an Italian based manufacturer of radios. The company’s senior management team has believed for several years that there is an opportunity to increase sales in the domestic market, and wish to set up a manufacturing subsidiary in Tanzania. Setting up the Tanzania subsidiary would involve construction of a new factory in Dar-es-salaam. The initial project cash investment is estimates at euro 1,000,000 divided as follows:

• Fixed assets                                      € 900,000• Working capital requirements      € 100,000

Production and sales are expected to be constant at 20,000 units per annum. The average price per radio is estimated as follows:

• year 1:                               TZS 55,000• year 2:                               TZS 53,000• Year 3:                               TZS 56,000• Year 4:                               TZS 59,000

The variable cost ratio is forecast at 30% of the selling price and is expected to remain constant. Annual fixed costs (excluding depreciation) are forecast at TZS 80,000,000. As per agreement between Gulf company and the authorities in Tanzania, depreciation expenses are not tax allowable. Inflation for each economy in the next four years is expected to be:

Italy 4%                             Tanzania 6%

The cost of capital for the company is 10%. The spot exchange rate is TZS 1,400/€. Corporate tax in Tanzania is 30%, in Italy 40%. Tax is payable, and allowances are available one year in arrears. The government of Tanzania is anxious to encourage foreign investment and thus allows overseas investors to repatriate an annual cash dividend equal to that year’s after-tax accounting profit. Cash remitted to Italy from the subsidiary is not taxable in Italy. The after-tax realizable value of the investment in four years’ time is expected to be approximately, TZS 200 million.

Required:

Evaluate whether Gulf company should establish the Tanzania subsidiary