(a) Why do companies make foreign direct investment? (b) A company...

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(a) Why do companies make foreign direct investment?
(b) A company in the UK, called Selly Oak plc, is contemplating acquiring a firm in Germany, called XYZ. The firm in Germany produces and sells only one product. During the year that has just ended today, the firm produced and sold 750,000 units of the product. Physical sales of the firm have been growing at the rate of 2% per annum during the last five years. This rate of growth is expected to continue in future. If XYZ is acquired, the selling price of its product will be €25 per unit in the first year and the price will increase by 5% in each subsequent year in future. Production costs will be €15 per unit in the first year, but the costs are expected to increase at the rate of 2% per annum in each subsequent year in future. Administrative cash expenses are expected to be €2,000,000 in the first year and they are expected to increase at the rate of 2% per annum in each subsequent year in future. A charge of €1,200,000 will be made for depreciation of plant and equipment in each year of operation of firm XYZ in future. The annual charge for depreciation will not increase in future.
All output of firm XYZ will be produced and sold at the end of each year of its operation. Also, all sales of the firm will be for cash, i.e. there will be no credit sale. Firm XYZ was incorporated in Germany and it will remain so after the acquisition. The firm will repatriate to the UK at the end of each year only 75% of the cash flows generated in years 1 and 2. But all the cash flows realised in year 3 will be repatriated at the end of that year. Assume that corporation tax rates in Germany and the UK will be 25% and 28% respectively for the next five years. The tax will be paid on current year basis, that is, any corporation tax due on the profits realised in each year will be paid at the end of the year.
If firm XYZ is acquired, it will be operated for three years and be sold for €16 million at the end of the three years.
No tax will be paid on this amount either in Germany or in the UK. All the cash flows that were not repatriated at the end of years 1 and 2 will be repatriated at the end of year 3 before the firm will be sold. Assume that spot exchange rate of one pound to the euro is €1.1100/£, nominal interest rates on the euro and the pound are 2% and 3% per annum respectively now, and they are expected to remain at this level for the next four years. The price that will be paid for firm XYZ, if it is acquired now, will be £17,500,000, and the cost of capital that will be used to assess the profitability of the firm is 15% per annum.
Given the information above, should Selly Oak plc acquire firm XYZ? State all other assumptions that you make.

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Answer a:
The main aim of foreign direct investment (FDI) is to reduce the country specific risk which is associated with the business portfolio if the operations are confined to one economy only. FDI helps the company to diversify its revenue base and reduce the overall risk. Second, FDI also help the company to expand its market base and spread the overall production costs over a larger output base, thereby reducing the cost per unit and increasing profits.
Third, FDI also helps...

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