Case Study of Am-Tel (US Comapnay) investment in Ko-Tel (Korean Comapny)

Product. The company (to be called "Ko-tel" hereafter) is expected to be a wholly owned Korean
manufacturer of customized integrated circuits (ICs) for use in computers, automobiles, and
robots. Ko-tel`s products would be sold primarily in Korea, and all sales would be denominated
in Korean won.
Sales. Sales in the first year are forecasted to be Won 26,000 million. Sales are expected to grow
at 10% per annum for the foreseeable future.
Working capital. Ko-tel needs gross working capital (that is, cash, receivables, and inventory)
equal to 25% of sales. Half of gross working capital can be financed by local payables, but the
other half must be financed by Ko-tel or Am-tel.
Parent-supplied components. Components sold to Ko-tel by Am-tel have a direct cost to Am-tel
equal to 95% of their sales price. The margin is therefore 5%.
Depreciation. Plant and equipment will be depreciated on a straight-line basis for both
accounting and tax purposes over an expected life of 10 years. No salvage value is anticipated.
License fees. Ko-tel will pay a license fee of 2.5% of sales revenue to Am-tel. This fee is taxdeductible in Korea but provides taxable income to Am-tel.
Taxes. The Korean corporate income tax rate is 35%, and the U.S. rate is 38%. Korea has no
withholding tax on dividends, interest, or fees paid to foreign residents.
Cost of capital. The cost of capital (or minimum required return) used in Korea by companies of
comparable risk is 22%. Am-tel also uses 22% as a discount rate for its investments.
Inflation. Prices are expected to increase as follows.
Korean general price level: +9% per annum.
Ko-tel average sales price: +9% per annum.
Korean raw material costs: +3% per annum.
Korean labor costs: +12% per annum.
U.S. general price level: +5% per annum.
Exchange rates. In the year in which the initial investment takes place, the exchange rate is Won
950 to the dollar. Am-tel forecasts the won to appreciate relative to the dollar at 1% per annum.

Dividend policy. Ko-tel will pay 70% of accounting net income to Am-tel as an annual cash
dividend. Ko-tel and Am-tel estimate that over a five-year period the other 30% of net income
must be reinvested to finance working capital growth.
Financing. Ko-tel will be financed by Am-tel with a $11,000,000 purchase of Won
8,250,000,000 common stock, all to be owned by Am-tel.
In order to develop the normal cash flow projections, Am-tel has made the following
assumptions.
1. Sales revenue in the first year of operations is expected to be Won 26,000 million. Won
sales revenue will increase annually at 10% because of physical growth and at an
additional 9% because of price increases. Consequently, sales revenue will grow at (1.1)
(1.09) = 1.20, or 20% per annum.
2. Korean raw material costs in the first year are budgeted at Won 4,000 million. Korean
raw material costs are expected to increase at 10% per annum because of physical growth
and at an additional 3% because of price increases. Consequently, raw material cost will
grow at (1.1) (1.03) = 1.13, or 13% per annum.
3. Parent-supplied component costs in the first year are budgeted at Won 9,000 million.
Parent-supplied component costs are expected to increase annually at 10% because of
physical growth, plus an additional 5% because of U.S. inflation, plus another 1% in won
terms because of the expected appreciation of the won relative to the dollar.
Consequently, the won cost of parent-supplied imports will increase at (1.1) (1.05) (.99) =
1.14 or 14% per annum.
4. Direct labor costs and overhead in the first year are budgeted at Won 5,000 million.
Korean direct labor costs and overhead are expected to increase at 10% per annum
because of physical growth, and at an additional 12% because of an increase in Korean
wage rates. Consequently, Korean direct labor and overhead will increase at (1.1)(1.12) =
1.232 or 12.32% per annum.
5. Marketing and general and administrative expenses are budgeted at Won 4,000 million,
fixed plus 4% of sales.
6. Liquidation value. At the end of five years, the project (including working capital) is
expected to be sold on a going-concern basis to Korean investors for Won 9,000 million,
equal to about $10 million at the expected exchange rate of won 903.44/$. This sales
price is free of all Korean and U.S. taxes, and will be used as a terminal value.