Capital Budgeting: A Case Study of Italy Custom Containers Corporation

• Introduce a case study on a topic (capital budgeting) covered in the course’s accounting prerequisites .

• Develop and apply material of the course prerequisites and the material covered in the course.

• Use simple linear regression models for forecasting

• Develop skills in Excel related to the presentation and computation of financial data

• Develop skills in critical analysis and decision making

• Develop business writing skills

• Increase awareness of ethical issues and transparency

The Italy Custom Containers Corporation (ICC) of Ciampino is contemplating entering into an agreement with the government of Georgia which is seeking to take advantage of its increasing production of petrochemicals. ICC would set up a turnkey plant that produces customized plastic industrial chemical containers that meet EU specifications.

ICC’s Board of Directors has decided to examine the offer from the Georgian government to set up the turnkey plant which will then be sold to the Georgian government after 3-years of successful operation. ICC’s management believes that setting up the turnkey plant in Georgia will position them as a leader in turnkey construction projects taking advantage of the increasing growth of trade between Italy and Georgia.

The following financial information on the proposed project is available. The estimated initial net investment in plant and equipment for 2021 is 4 million euro which must be converted to Georgian lari (GEL) at the current exchange rate of 3.35 GEL per euro. This initial investment will be fully depreciated over a 16 year period (the straight line method of depreciation is used.) Full capacity operation of the plant is 4600 units per year. ICC will provide the capital in the form of equity and debt.

The project will begin operating in 2021. At the end of 3 years of operations, in 2024, the company plans to sell the plant to the Georgian government at a P/EBITDA multiple of 8X. This amount, plus any other accumulated cash, will be repatriated as a final terminal payment to ICC. ICC’s beta is 1.4 the risk-free rate is 1.8 percent and the market risk premium is 6.0 percent. The after-tax cost of debt for ICC is 9.0 percent. Currently ICC’s optimal capital structure is 75 percent equity and 25 percent debt.

As part of the agreement, the Georgian government has imposed capital controls on the repatriation of euro for this project. A maximum of 400,000 euro may be repatriated for the first two years of operation. An excess of cash flows may be invested in a local government fund that has a guaranteed return of 6.4 percent compounded monthly. The amount accumulated in this fund may be repatriated after the two years.

Case: Italy Custom Containers (fictitious corporation)

The ICC’s effective Georgian corporate income tax rate is 22 percent on the gross profit margin. However, the ICC receives a tax credit for taxes already paid to foreign governments. In the case of the terminal payment, the tax treatment is different. The Georgian government will not tax this terminal payment. ICC has obtained a ruling from the Italian tax authorities that the terminal payment will also not be taxed by the Italian government. The Italian tax on foreign earned income is 24%.

Inflation rates in the EU are expected to be 1.6 percent per annum; inflation in Georgia has ranged from 4 percent to 8 percent over the recent period.

Historical information on demand for containers and production costs is available for another of the company’s turn key operations in a similar market (see below). ICC believes these data provide the best basis from which to forecast demand and costs for the proposed Georgian plant. The gross profit margin for is estimated to be 20 percent though this has ranged from 5 percent to 30 percent for similar plants. 

The price per container has been established at 4800 GEL for 2021. Prices are expected to vary greatly based upon market demand for containers.

Answer the following question in the form of a short summary paper (3 pages DOUBLE SPACE, type 12 font – points will be taken off for reports in excess of 3 pages). This page limitation does not include your technical appendix and any other relevant documentation. You need to include a risk analysis as part of your project (use the textbook as a reference as there is quite a bit of information available that you should include in the project analysis).

What is your recommendation for the project?

(i) A summary page of your recommendations (and why) for the foreign subsidiary project

(ii) Attached spreadsheets showing your analysis and any documentation explaining your work

The documentation is very important – part of your grade will be based upon whether or not someone can easily follow your analysis. Thoughtful, clear and well developed recommendations will receive additional weight.

1. Begin by describing the project under consideration including relevant details as well as summary numbers.

2. Provide a summary of your financial analysis of the project. Inclusion of well-documented tables and charts can be useful to present your information (especially scenarios). Make sure you document carefully and support your scenarios. You are strongly encouraged to include a discussion of real options in your analysis.

3. Include tables-charts in the text to make it easy for the reader to see the most relevant information as opposed to constantly referring to a table in an Appendix.