Thesis on "Global Financial Investment"

Thesis 8 pages (2193 words) Sources: 10 Style: APA

[EXCERPT] . . . .

Global Financial Investment

Globalization has allowed economic agents to transcend boundaries and expand their operations to various global regions. But this ability has also materialized in the need to face risks of larger degrees and to develop the most adequate solutions that respond to the risks of conducting international operations. To better understand this concept, it is important to assess a real life situation, that of the American Wilson Company that is looking to invest $12 million in a joint venture in China to produce and sell videocassettes. In deciding the most favorable course of action, the managers at the United States company have to respond to questions such as the cost of capital, the net present value, the determinants of profitability, the capital structure or the exchange rate risk.

Cost of Capital and Rate of Return

In a most simplistic formulation, the cost of capital represents "the opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected" (Investor Words, 2009). In calculating the value of the cost of capital, investors add up the cost of debt and the cost of equity. In the case of the Wilson Company, the cost of capital exceeds the value of $4 million.

The second concept of this section, that of the rate of return, refers to "the gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus realized capital gains" (Investopedia, 2009). In thi

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s particular context, it refers to the money that the $12 million investment will generate. The simplest way of calculating the rate of return is that of dividing the subtraction of the initial investment from the final result by the investment. Otherwise put:

Rate of Return = [(Return -- Capital) / Capital] x 100 (Think Quest Library)

In order to achieve this however, it is necessary to identify the expected results of the joint venture. It is estimated to generate profits of 60, 80 and 100 million respectively, throughout the first three years of operations. These profits are equally shared by the Chinese and American parties and subjected to taxation. In the first scenario, the rates of return are calculated based on a 30% tax rate and the second scenario sees that the tax rate is of 40%. Subcategories a and b refer to the composition of the return. Scenarios 1.a and 2.a include the costs of capital in the return but scenarios 1.b and 2.b extract it from the return of the investment. This is necessary to view the matter from two standpoints and this ability is given by the fact that the actual calculation of the rate of return is a rather relative action. "Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation" (Investopedia).

3. Net Present Value and the Discrete Probability Distribution

The concept of Net Present Value is derived from the theories of the time value of money which argue that a dollar earned today is more valuable than a dollar earned in the future. This is explained by the simple argument that future periods are expected to be affected by inflation, decreasing as such the purchasing power of the dollar. Today however, the dollar is able to be invested and grow (FinAid, 2009). The attached excel file presents the expected NPV, measured based on ten estimated cash flows and the investment's discount rate, or its cost of capital. Throughout its three years, the joint venture in China is expected to generate total cash flows in the amount of $79,605,125.98 and the net present value is measured at $67,605,125.98. The figures indicate that the investment could be worth pursuing by the Wilson Company (Investopedia).

4. Recommendation to Investment

As pointed out in the previous section, the value of the project and its expected returns reveal highly successful outcomes, meaning as such that the United States-based organization should consider the joint venture in China. This would be beneficial not only for the immediate financial benefits, but also for its ability to generate future monetary gains. The investment could for instance open the door to a new and wide international market where Wilson could begin to sell its products. Also, it could open the door to numerous potential partners that would present the Wilson Company with a broad range of comparative advantages, such as cost effective labor force, abundance of resources and technological innovations. All in all, in terms of gains in both short- and long-term future, the Wilson-based company should sign the deal with its Chinese counterpart and commence the production and sale of videocassettes.

5. Determinants of Profit

The key determinant of profits in the Chinese -- American joint venture is indisputably the ability of the managerial team to develop and implement the most suitable strategic courses of action. They must for instance be able to identify and remove any barriers, including cultural limitations. Then, they must be able to create a product that is desired by the consumers and that will not pose major barriers to selling. Furthermore, they must ensure that the production of their videocassettes is efficiently handled, meaning that it is able to generate sustainable profits within the given resource restrictions. Otherwise put, they must maximize profits while in the same time minimizing resource consumption. These resources are vast and include components such as capitals, labor force, commodities or technologies.

Greg Roworth (2005) identified seven vital components of a successful venture, regardless of location, time zone or other features. These can also be applied by the American -- Chinese joint venture to enhance their chances of successful outcomes:

taking charge, action and responsibility -- the U.S. managers might initially feel reluctant to an aggressive approach but should not be intimidated by the foreign character of the business establishing financial, marketing and organizational goals that are SMART -- "specific, measurable, achievable, relevant and time-framed" (Walesh, 2003)

maintaining strong communications that promote the organizational products and goals; adequate marketing strategies are vital at this stage create customer satisfaction and loyalty to the product, the brand and the company; a loyal customer base not only generates sustainable revenues, but is also able to reduce marketing costs (N Touch Loyalty, 2008)

offering extensive training programs so that the human resource is able to adequately handle its tasks and deliver high quality products and services always remaining alert to the changes that might be affecting the American and Chinese markets and industries and developing strategies that adapt and respond to the emergent challenges finally, organizations need to celebrate their victories and by this, motivate and encourage their staff members.

6. Structure of Capitals

The capital structure can be looked at through the lens of its costs, mostly the cost of debt and the cost of equity. "The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two)" (Investopedia). The managerial team at the Wilson Company decided to fund its operations by using 60% debt and 40% equity. The decision seems logical given the increased cost of using equity relative to the decreased cost of using debt. Additionally, when using equity, Winston pays more in taxes as well, since the money distributed in the form of dividends are accounted for as profits and as such taxed. On the other hand, the loan reimbursements are accounted for as debt and not taxed by either state (Fabozzi and Peterson, 2003).

However, financing through equity does reveal some advantages over debt financing and could be chosen in given circumstances. For instance, investors are more flexible than creditors and equity could be chosen in favor of debt whenever the joint venture has made major plans for the future and they would want to invest most of their money in committing to those plans. In this light of events, the stockowners could be pursued to not cash in their dividends, but vote that the profits remain within the company and be further invested, for the company's benefit, as well as for their own future gains.

Another situation in which the American -- Chinese joint venture could opt for equity in the detriment of debt is given by encountered financial difficulties or the already existence of extensive debt. In either of these instances, the company would be unable to contract bank loans and its second best solution would be that of issuing stocks. Equity buyers accept the fact that they will only be remunerated once the company becomes profitable and they are such more flexible; also, since… READ MORE

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Quoted Instructions for "Global Financial Investment" Assignment:

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*****: *****

Answer the questions at the end of the Global Investment Exercise. Your numerical analysis should be in an Excel file and the discussion of your solution in a file formatted in Rich Text Format.

Global Investment Exercise

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 yuan renmimbi, the Chinese currency) can be converted to U.S. dollars at an exchange rate of RM1 = $.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 RM)

1 60 million

2 80 million

3 100 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.

2. Determine the discrete probability distribution of Wilson's Net Present Value for this joint venture and calculate the Expected Net Present Value.

3. Would you recommend that Wilson 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 China as a result of the joint venture?

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?

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.

NOTE: This exercise has been adapted from an exercise on page 519 in Jeff Madura's International Financial Management (1999), South-Western College Publishing.

How to Reference "Global Financial Investment" Thesis in a Bibliography

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