Scot plc is a successful manufacturing company based in the north of England. As a result of the changing relationship between the European Union and eastern European countries, an opportunity has arisen to invest in Glumrovia. The directors of Scot plc have decided that, because of the risky nature of investments in this part of the world, they will require an after-tax return of at least 20 per cent on the project.
The government of Glumrovia is prepared to grant Scot plc a five-year licence to operate in the country. Market research suggests that cash flows from the project, in Glumrovian dollars (G$), will be as follows:
Year
|
1
|
2
|
3
|
4
|
5
|
G$000
|
250
|
450
|
550
|
650
|
800
|
However, much of the increase in the project cash flows is due to expected rates of inflation. The current G$/sterling exchange rate is G$3.00/£1; in subsequent years it is expected to be:
Year
|
1
|
2
|
3
|
4
|
5
|
G$/£
|
4.00
|
5.00
|
6.00
|
7.00
|
8.00
|
The project will cost G$600 000 to set up, but the present Glumrovian government will pay G$600 000 to Scot plc for the business at the end of the five-year period. It will also lend Scot plc the G$250 000 required for initial working capital at the advantageous rate of 6 per cent, to be repaid at the end of the five-year period.
Scot plc will pay Glumrovian tax on the after-interest profits at the rate of 20 per cent. Glumrovian tax is payable at the end of each year, at which time the balance of profits can be remitted to the UK. There is a tax treaty between the two governments and so any Glumrovian tax paid can be offset against UK tax liability. UK tax is payable at the rate of 30 per cent and you should assume that it is payable at the time that the cash is remitted to the UK.
As yet, there is no stock exchange in Glumrovia as the current liberal government has been unable to complete the implementation of necessary economic reforms.
A recent press report revealed that the people of Glumrovia are disappointed with the pace of liberal reform and that elections to be held next year might see a significant renewal of communist influence.
(a) Prepare a report for Scot plc that analyses the data available and makes an argued recommendation as to whether the project should be taken on.
(b) Discuss the possible problems that might confront a company making the type of decision facing Scot plc.