Gandor Co. is a U.S. ﬁrm that is considering a joint venture with a Chinese ﬁrm to produce and sell videocassettes. Gandor will invest $12 million in this project, which will help to ﬁnance the Chinese ﬁrm’s production. For each of the ﬁrst 3 years, 50 per- cent 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 United States. The Chinese government intends to impose a 20 percent income tax on the proﬁts distributed to Gandor. The Chinese government has guaranteed that the after-tax proﬁts (denomi- nated in yuan, the Chinese currency) can be converted to U.S. dollars at an exchange rate of $.20 per yuan and sent to Gandor Co. each year. At the current time, no with- holding tax is imposed on proﬁts sent to the United States as a result of joint ventures in China. Assume that after considering the taxes paid in China, an additional 10 per- cent tax is imposed by the U.S. government on proﬁts received by Gandor Co. After the ﬁrst 3 years, all proﬁts earned are allocated to the Chinese ﬁrm.
The expected total proﬁts resulting from the joint venture per year are as follows:
Total Proﬁts from Joint Venture (in yuan)
Gandor’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 Gandor is nor- mally 30 percent. Gandor uses a capital structure composed of 60 percent debt and 40 percent equity. Gandor automatically adds 4 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Though this project has particular forms of country risk that are unique, Gandor plans to account for these forms of risk within its estimation of cash ﬂows.
Gandor is concerned about two forms of country risk. First, there is the risk that the Chinese government will increase the corporate income tax rate from 20 to 40 percent (20 percent probability). If this occurs, additional tax credits will be al- lowed, 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 United States (20 percent probability). In this case, additional tax credits will not be allowed, and Gandor will still be subject to a 10 per- cent U.S. tax on proﬁts received from China. Assume that the two types of country risk are mutually exclusive. That is, the Chinese government will adjust only one of its taxes (the income tax or the withholding tax), if any.
1 Determine Gandor’s cost of capital. Also, determine Gandor’s required rate of return for the joint venture in China.
2 Determine the probability distribution of Gandor’s net present values for the joint venture. Capital budgeting analyses should be conducted for these three scenarios:
• Scenario 1. Based on original assumptions.
• Scenario 2. Based on an increase in the corporate income tax by the Chinese government.
• Scenario 3. Based on the imposition of a withholding tax by the Chinese government.
3 Would you recommend that Gandor participate in the joint venture? Explain.
4 What do you think would be the key underlying factor that would have the most inﬂu- ence on the proﬁts earned in China as a result of the joint venture?
5 Is there any reason for Gandor to revise the composition of its capital (debt and eq- uity) obtained from the United States when ﬁnancing joint ventures like this?
6 When Gandor was assessing this proposed joint venture, some of its managers recom- mended that Gandor borrow the Chinese currency rather than dollars to obtain some of the necessary capital for its initial investment. They suggested that such a strategy could reduce Gandor’s exchange rate risk. Do you agree? Explain.