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Required Rate of Return

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Required Rate of Return

United Automobiles projects to expand its international business operations by opening up sub-branches in various countries. The first major production centre will be opened in Vancouver, Canada. The project is expected to consumer $780,000, and the company forecast high returns and profit margin. The rate of return for the Vancouver project will be derived using CAPM whereby the risk-free rate of return will be subtracted from the market rate of return. The result will then be multiplied by the beta of Canadian market security. The final result will then be added to the current risk-free rate of return for this will help derive the final required rate of return for the Vancouver project.  The Canadian market has continuous shifts in the economic elements, which makes the rates not stable; therefore the company have put in place currency and exchange risk mitigation factors.

Estimating Cash Flows

To estimate the revenues for the Vancouver project, the firm will start with analyzing its expected expenses. In this case, all operating expenses, wages and salaries, office suppliers, location cost, project insurance, among other expenses. After the total expenses are estimated, then we will calculate fixed costs or overhead costs and variable costs. The next step will forecast revenue via conservative case factoring in any fluctuations in the market ratios. It is necessary at this step to check in essential ratios to ensure that the company projections are practical.  Finally, the firm gross margin and operating profit will be projected based on the total revenues and total expenses.

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Valdez, Schmitz & Englin (2019, p 60) pointed out that net cash flows are the total amount of cash produced from operating a business for some time. In this project, the net cash flow will be estimated for six months. It will be derived from the statement of cash flows through a formula (CFO + CFI + CFF). This will give the net cash that the entire business will generate from all its operations within six months.  The total amount of inflows and outflows will be converted into euros.

Vancouver project is considered a prospective project. If the firm only focuses on income statements and budgets to calculate the net cash flows, then it means that future projections are ignored. Further, it implies that capital expenditure will require large cash flows.  This condition would result in what is called tunnel vision regarding the Vancouver project, which is associated with overestimation of net cash flows.

Assessing Exposure to Country Risk

For international business, there are various financial factors that exposure business operations to risk.  United Automobiles, is exposed to financial risks such as market fluctuations in currency, exchange risks, inflations and recession gaps, interest rates and discount rates. For example, a reduction in the value of the currency that the business will be using implies a loss to the company. Inflation in the country results to decrease in the amount of money and consumer’s purchasing power, a situation not desirable for international business operations.

Political instability is an adverse factor in the business. In the case of political polarization in the country, the company will not have a favourable business environment for smooth operations.  Further, the political relationship between Canada and the United States has a significant impact on United Automobiles.

 

 

Capital Structure Decisions

The capital structure will be composed of equity capital, reserves and borrowing. The firm will have a balanced capital structure with the best mix of debt, preferred stock, equity and common stock (Confidence & Lawrence 2019, n.d). This will maximize the firm’s market value and minimize the cost of capital. For the Vancouver project, the structure will be composed of $160,000 assets and $60,000 liabilities. The amount of equity will, therefore, be $100,000. From the above, the use of equity will be limited with a ratio of 1 because it is a startup business.

Long-Term Debt-Denomination Decision

United States Interest Rates (CAD per 1 USD, n.d)

Calendar          GMT               Actual Previous          Consensus                               TEForecast

2019-07-31      06:00 PM        Fed Interest Rate Decision     2.25%  2.5%    2.25%  2.25%

2019-09-18      06:00 PM        Fed Interest Rate Decision     2%       2.25%  2%       2%

2019-10-30      06:00 PM        Fed Interest Rate Decision     1.75%  2%       1.75%  1.75%

2019-12-11      07:00 PM        Fed Interest Rate Decision     1.75%  1.75%  1.75%  1.75%

2020-01-29      07:00 PM        Fed Interest Rate Decision                 1.75%              1.75%

Canadian Interest Rates (CAD per 1 USD, n.d)

Calendar          GMT               Actual Previous          Consensus       TEForecast

2019-07-10      02:00 PM        BoC Interest Rate Decision    1.75%  1.75%  1.75%  1.75%

2019-09-04      02:00 PM        BoC Interest Rate Decision    1.75%  1.75%  1.75%  1.75%

2019-10-30      02:00 PM        BoC Interest Rate Decision    1.75%  1.75%  1.75%  1.75%

2019-12-04      03:00 PM        BoC Interest Rate Decision    1.75%  1.75%  1.75%  1.75%

From the above rates, the United States interest rates are higher than that of Canada. The firm will then borrow in the USD. Long term borrowing in the foreign currency reduces exposure to exchange rate risk because the firm reduces its rate of transactions. In this case, long term borrowing in Canadian dollars would help the firm reduce its exposure risks to fluctuations in exchange rates. The firm will be stable with enough financial base in the country.

Ensuring Payment for Exports

The business will operate in two types of payment methods which are paid in advance and immediate payment. Customer will be required to pay for the vehicles when placing orders either online or through the company offices. A loyal customer will be allowed to make payments immediately after delivery. This will give them time to assess for the actual vehicles they ordered. The company will have a system that monitors all the payments made to the firm for transparency, accuracy and honesty.

Financing in Foreign Currency

From the observation of the interest rates above USD is higher than Canadian dollars. In this case, the firm would use Canadian dollars to offset the receivables. This can be done by setting up the Canadian currency account to enable the firm to accept most of its payment in the Canadian dollar. The firm will also encourage its buyers to convert their payment in Canadian dollar before they deposit into the firm’s account. This will reduce the firm’s exposure to exchange risks hence reducing losses during transactions within and out of the country.

The firm will reduce exchange risk exposure by foreign financing whereby all the borrowings are done in the foreign currency. Also, the firm can involve a forward exchange contract in which it can buy one currency and even sell them at a fixed rate in the future date. The firm will also encourage its buyers to convert their payment in Canadian dollar before they deposit into the firm’s account. This will reduce the firm’s exposure to exchange risks hence reducing losses during transactions within and out of the country. Customer will be required to pay for the vehicles when placing orders either online or through the company offices. A loyal customer will be allowed to make payments immediately after delivery

Managing Cash

After receiving the payments, the firm will prioritize settlement of short term debts and then long term debts. After payment of debts, the firm will later pay for expenses that the company incurred for the first six months. This includes wages and salaries, operating expenses, insurance, among others. The remaining cash will then be invested in short term securities. However, cash expenditure will strictly follow a list of priorities, as indicated in the company budget. The cash will be converted to Canadian dollar before expense.

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