FNCE 4103 Week 9 Cross-Border Capital Budgeting Example

Should Lakeland Build an Assembly Plant in Querétaro? Peso Cash Flows, an 80 Percent Remittance Policy, a 5 Percent Treaty Withholding Tax and Five Years of Exchange Rates Turned Into a Dollar NPV of About $2.8 Million

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Walden University

FNCE 4103: International Finance

Instructor Name

Month Day, Year

Should Lakeland Build an Assembly Plant in Querétaro? Peso Cash Flows, an 80 Percent Remittance Policy, a 5 Percent Treaty Withholding Tax and Five Years of Exchange Rates Turned Into a Dollar NPV of About $2.8 Million

The Project

Lakeland Process Equipment, the composite Minneapolis manufacturer studied this term, is considering a $12 million assembly plant in Querétaro, Mexico, to build lower-priced processing lines for Latin American customers. The plant would be owned by a Mexican subsidiary that pays Mexican corporate tax and remits 80 percent of its after-tax cash to Minneapolis as dividends each year. The parent evaluates the project on the dollars it actually receives, discounted at a 12 percent dollar rate that reflects the project's risk (Shapiro & Hanouna, 2019). All amounts are in millions.

From Pesos to the Parent's Dollars

Net present value to the parent: −$12.0 + $14.75 = about $2.75 million.

Table 1

Project Cash Flows From the Subsidiary to the Parent (in millions)

Composite project; peso cash flows, exchange rates and terminal value as specified for the exercise. The initial investment of $12.0 million is made at year 0.

Each Step Explained

Remittance policy. The subsidiary keeps 20 percent of its cash to fund working capital and maintenance. That retained cash is not counted as a receipt by the parent each year; it is assumed to build value inside the subsidiary, which the terminal value captures.

Withholding tax. Mexico taxes dividends paid to foreign shareholders. Under the income tax treaty between the United States and Mexico, the rate on dividends paid to a U.S. company owning at least 10 percent of the payer is reduced to 5 percent (Internal Revenue Service, n.d.). The table applies that rate.

Exchange rates. The rates are those specified for the exercise, a peso weakening about 3 percent a year from 18.0 to 20.4 per dollar, broadly consistent with the inflation gap between the two countries. Each year's dividend is converted at that year's rate.

Terminal value. In year 5, the subsidiary itself is valued at MXN 300 million, roughly six times its final-year cash flow, and converted at 20.4. It accounts for about 57 percent of the present value of the project's inflows.

Sensitivity

Two tests matter. If the peso weakened 6 percent a year instead, to about 24.1 per dollar by year 5, the project would be worth only about $0.8 million to the parent, positive but thin. Without the terminal value the project would show a loss of about $5.6 million, so the decision rests heavily on the subsidiary still being worth MXN 300 million in five years. Eiteman et al. (2021) note that terminal values often dominate foreign project valuations and deserve the same scrutiny as the near-term cash flows.

The Local View

The same project can look different from Mexico. Measured in pesos, before remittance and withholding and with all cash counted, the plant generates more value, because the 20 percent retained and the 5 percent withheld never appear as losses to the subsidiary. A project can therefore be attractive locally and marginal to the parent. The parent's view governs the decision, because Lakeland's shareholders own dollars, but the local view matters for the subsidiary's managers, whose performance should be judged on what they control.

Blocked Funds

Mexico does not currently restrict dividend remittances, so no blocked amounts are assumed. If the government imposed controls, the parent's receipts would be delayed or reduced even if the plant performed well. That risk is assessed in the country risk brief rather than built into these cash flows.

Recommendation

The project adds value at the specified exchange rates, but its value depends on the terminal value and on the peso not weakening much faster than inflation differences imply. Lakeland should proceed only if it is confident the Latin American market will support the plant beyond year 5, and it should consider financing part of the investment in pesos, so that peso debt offsets some of the currency risk on peso earnings (Madura, 2021).

References

Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2021). Multinational business finance (15th ed.). Pearson.

Internal Revenue Service. (n.d.). United States income tax treaties: A to Z. https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z

Madura, J. (2021). International financial management (14th ed.). Cengage Learning.

Shapiro, A. C., & Hanouna, P. (2019). Multinational financial management (11th ed.). Wiley.