The Brazilian government has guaranteed that the after-tax profits (denominated in Reals, the Brazilian currency) can be converted to US dollars at the current exchange rate and sent to the Gibson Company each year. Current exchange rates can be found at http://www.oanda.com.
For each of the first five years, 60 percent of the total profits will be distributed to Brasilia, while the remaining 40 percent will be converted to dollars to be sent to Gibson. The income tax rate for the joint venture will be 10%. However, the Brazilian government is considering raising the income tax rate to 30%. At the present time, the Brazilian government doe not impose a separate income tax on profits sent out of the country. However, the Brazilian government is considering imposing an additional 10 percent income tax on profits distributed to a foreign company. Assume that there are no other forms of tax. After considering the taxes paid in Brazil, assume an additional seven percent tax imposed by the US government on profits received by Gibson Company.
The expected total profits resulting from the joint venture per year are as follows:
Year Total Profits from Joint Venture (in BRL)
1 40 million
2 60 million
3 70 million
4 90 million
5 120 million
Gibson’s average cost of debt is 6 percent before taxes. Its average cost of equity is 9 percent. Assume that Gibsonâ€™s US income tax rate is 10 percent. Gibsonâ€™s capital structure is 70 percent debt and 30 percent equity. Gibson adds between 2 and 5 percentage points to its cost of capital when deriving its required rate of return on international joint ventures. Gibson plans to account for country and other risks within its cash flow estimates.
Gibson is concerned about country risk in the following two forms:
(1) Will the Brazilian government increase the corporate income tax rate from 10 percent to 30 percent (20 percent probability)? If this occurs, Gibson will receive additional tax credits on its US taxes, resulting in no US taxes on the profits from this joint venture.
(2) Will the Brazilian government impose a separate income tax of 10 percent on the profits distributed to foreign companies such as Gibson (20 percent probability)? If this occurs, Gibson will not receive additional tax credits, and the company will still be subject to US tax on the profits from this joint venture.
Assume that the two types of country risk are mutually exclusive. If it does anything, the Brazilian government will only implement one of these changes in its tax policies (i.e., the increase in the basic income tax on the profits of the joint venture or the additional income tax on profits distributed to foreign companies). The Brazilian government may also choose to leave things as they are.
1. Determine Gibson’s cost of capital and required rate of return for the joint venture in Brazil.
2. Determine the discrete probability distribution of Gibson’s Net Present Value for this joint venture and calculate the Expected Net Present Value.
3. Would you recommend that Gibson 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 Brazil as a result of the joint venture?
5. Under what circumstances might Gibson 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 Gibson was assessing this proposed joint venture, some of the managers in the company recommended that it borrow the Brazilian currency rather than using US dollars to obtain some of the necessary capital for the initial investment. They suggested that such a strategy could reduce Gibsonâ€™s exchange rate risk. Do you agree? Explain.
7. Discuss the benefits of the joint venture from the perspective of Brasilia. What is the maximum amount of money Brasilia should invest?