Wilson Company's joint venture investment in China: financial analysis and risk assessment

Global Financial Investment

Globalization has allowed economic agents to transcend boundaries and expand their operations to various global regions. But this ability has also materialized in the need to face risks of larger degrees and to develop the most adequate solutions that respond to the risks of conducting international operations. To better understand this concept, it is important to assess a real life situation, that of the American Wilson Company that is looking to invest $12 million in a joint venture in China to produce and sell videocassettes. In deciding the most favorable course of action, the managers at the United States company have to respond to questions such as the cost of capital, the net present value, the determinants of profitability, the capital structure or the exchange rate risk.

Cost of Capital and Rate of Return

In a most simplistic formulation, the cost of capital represents "the opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected" (Investor Words, 2009). In calculating the value of the cost of capital, investors add up the cost of debt and the cost of equity. In the case of the Wilson Company, the cost of capital exceeds the value of $4 million.

The second concept of this section, that of the rate of return, refers to "the gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus realized capital gains" (Investopedia, 2009). In this particular context, it refers to the money that the $12 million investment will generate. The simplest way of calculating the rate of return is that of dividing the subtraction of the initial investment from the final result by the investment. Otherwise put:

Rate of Return = [(Return -- Capital) / Capital] x 100 (Think Quest Library)

In order to achieve this however, it is necessary to identify the expected results of the joint venture. It is estimated to generate profits of 60, 80 and 100 million respectively, throughout the first three years of operations. These profits are equally shared by the Chinese and American parties and subjected to taxation. In the first scenario, the rates of return are calculated based on a 30% tax rate and the second scenario sees that the tax rate is of 40%. Subcategories a and b refer to the composition of the return. Scenarios 1.a and 2.a include the costs of capital in the return but scenarios 1.b and 2.b extract it from the return of the investment. This is necessary to view the matter from two standpoints and this ability is given by the fact that the actual calculation of the rate of return is a rather relative action. "Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation" (Investopedia).

3. Net Present Value and the Discrete Probability Distribution

The concept of Net Present Value is derived from the theories of the time value of money which argue that a dollar earned today is more valuable than a dollar earned in the future. This is explained by the simple argument that future periods are expected to be affected by inflation, decreasing as such the purchasing power of the dollar. Today however, the dollar is able to be invested and grow (FinAid, 2009). The attached excel file presents the expected NPV, measured based on ten estimated cash flows and the investment's discount rate, or its cost of capital. Throughout its three years, the joint venture in China is expected to generate total cash flows in the amount of $79,605,125.98 and the net present value is measured at $67,605,125.98. The figures indicate that the investment could be worth pursuing by the Wilson Company (Investopedia).

4. Recommendation to Investment

As pointed out in the previous section, the value of the project and its expected returns reveal highly successful outcomes, meaning as such that the United States-based organization should consider the joint venture in China. This would be beneficial not only for the immediate financial benefits, but also for its ability to generate future monetary gains. The investment could for instance open the door to a new and wide international market where Wilson could begin to sell its products. Also, it could open the door to numerous potential partners that would present the Wilson Company with a broad range of comparative advantages, such as cost effective labor force, abundance of resources and technological innovations. All in all, in terms of gains in both short- and long-term future, the Wilson-based company should sign the deal with its Chinese counterpart and commence the production and sale of videocassettes.

5. Determinants of Profit

The key determinant of profits in the Chinese -- American joint venture is indisputably the ability of the managerial team to develop and implement the most suitable strategic courses of action. They must for instance be able to identify and remove any barriers, including cultural limitations. Then, they must be able to create a product that is desired by the consumers and that will not pose major barriers to selling. Furthermore, they must ensure that the production of their videocassettes is efficiently handled, meaning that it is able to generate sustainable profits within the given resource restrictions. Otherwise put, they must maximize profits while in the same time minimizing resource consumption. These resources are vast and include components such as capitals, labor force, commodities or technologies.

Greg Roworth (2005) identified seven vital components of a successful venture, regardless of location, time zone or other features. These can also be applied by the American -- Chinese joint venture to enhance their chances of successful outcomes:

taking charge, action and responsibility -- the U.S. managers might initially feel reluctant to an aggressive approach but should not be intimidated by the foreign character of the business establishing financial, marketing and organizational goals that are SMART -- "specific, measurable, achievable, relevant and time-framed" (Walesh, 2003)

maintaining strong communications that promote the organizational products and goals; adequate marketing strategies are vital at this stage create customer satisfaction and loyalty to the product, the brand and the company; a loyal customer base not only generates sustainable revenues, but is also able to reduce marketing costs (N Touch Loyalty, 2008)

offering extensive training programs so that the human resource is able to adequately handle its tasks and deliver high quality products and services always remaining alert to the changes that might be affecting the American and Chinese markets and industries and developing strategies that adapt and respond to the emergent challenges finally, organizations need to celebrate their victories and by this, motivate and encourage their staff members.

7. Exchange Rate Risk

Some managers at the Wilson Company argued that the organization should contract its loans in Renminbi, or the Chinese currency. The measure would, according to them, help the company protect itself against currency exchange risks. Considering that the company comes to disregard this suggestion, the situation would present itself as follows:

the exchange rate is of one RM to 0.2 USD, meaning basically that a United States dollar can be purchased for 5 Renminbis

the failure to protect against currency risks is similar to speculative actions in the meaning that it can materialize in both gains as well as loses; however, the two are mutually exclusive meaning that only one trend can be observed for a given venture

in this order of ideas, if the Chinese Renminbi suffers a process of devaluation, it becomes less able to purchase United States dollars; consequently, this means that Wilson registers financial gains as its national currency has become stronger in comparison to the local one and that a U.S. dollar is able to purchase more Chinese RMs

secondly, if the Chinese RMs become stronger, the same amount of Chinese currency is able to purchase larger amounts of American currency; consequently, this means that the Wilson Company is subjected to financial losses due to a devaluation of the American dollar in comparison to the Chinese Renminbi

With these considerations in mind, the managerial team at the United States-based organization has to make a decision. The ultimate course of action will depend directly on the company's risk aversion. Otherwise put, they will have to compare their desire for positive gains against the possibility of losses. If the desire for gains is strong and the aversion to risk is low, the company will chose not to hedge against currency risks. If on the other hand the aversion to risk is high and outweighs the possibility of easy gains, the managers at the Wilson Company will choose to protect themselves against currency risks and a means of achieving this is that of borrowing also in Chinese Renminbis instead of just American dollars. This measure will ensure that the company is not affected by fluctuations in the Chinese currency (Hull, 2003).

8. Conclusions

The growing forces of globalization and market liberalization motivate more and more economic agents to expand their operations to other geographic regions. China is a popular destination for many American organizations due to the comparative advantages it offers, such as cost effective labor force or an abundance of technological innovations. The U.S.-based Winston Company is currently assessing the possibility of a joint venture with a company in China to produce and sell videocassettes. A financial analysis of the business proposition reveals that it stands increased chances of success, and that it would manage to retrieve the desired rates of return given that the managerial teams are able to develop and implement the adequate courses of action.

References:

Fabozzi, F.J., Peterson, P.P., 2003, Financial Management and Analysis, 2nd Edition, John Wiley and Sons, ISBN: 0471234842

Hull, J.C., 2003, Options, Futures and Other Derivatives, Prentice Hall, ISBN 0130091448

Roworth, G., 2005, The 7 Keys to Business Success, Buzzle, http://www.buzzle.com/editorials/4-25-2005-69063.asp last accessed on May 18, 2009

Walesh, S.G., 2003, Managing and Leading: 52 Lessons Learned for Engineers, ASCE Publications, ISBN 0784406758

2009, Investor Words, http://www.investorwords.com last accessed on May 18, 2009

Investopedia, last accessed on May 18, 2009

2009, Net Present Value, FinAid, http://www.finaid.org/loans/npv.phtml last accessed on May 18, 2009

2002, Debt vs. Equity?, Dynamic Equity, http://www.dynamic-equity.com/vcmag03.htm last accessed on May 18, 2009

2008, Customer Loyalty, N Touch Loyalty, http://www.ntouchloyalty.com / last accessed on May 18, 2009

Calculating the Rate of Return on Investments, Think Quest Library, http://library.thinkquest.org/3096/42analy2.htm last accessed on May 18, 2009