Washi Co is a large, unlisted company based in Japan and its local currency is the Japanese Yen (JPY). It manufactures industrial equipment and parts. Initially Washi Co’s customers consisted of other Japanese companies, but over the last 12 years it has expanded into overseas markets and also sources its materials from around the world. The company’s board of directors (BoD) believes that the strategy of overseas investments, through subsidiary companies, branches and joint ventures, has directly led to the company’s substantial increase in value in the past few years.

Washi Co’s BoD is considering investing in a project based in Airone, whose currency is the Airone Rand (ARD). It believes that the project will be an important addition to the company’s portfolio of investments, because Washi Co does not currently have a significant presence in the part of the world where Airone is located. It is intended that the project will commence in one year’s time. Details of the project are given below.

Washi Co intends to finance the project through proceeds from an agreed sale of a small European subsidiary, with any remaining funding requirement being met by additional debt finance issued in Japanese Yen. The company is due to receive the proceeds from the sale of a European subsidiary company in six months’ time and it will then invest these funds in short-dated Japanese treasury bills for a further six months before they are needed for the project. Washi Co has a centralised treasury department, which hedges expected future cash flows against currency fluctuations.

Funding and financial information
The agreed proceeds from the sale of the European subsidiary company receivable in six months’ time are Euro (EUR) 80 million. The BoD is concerned about a negative fluctuation in EUR/JPY rate between now and in six months when the EUR 80 million will be received. Therefore, it has asked Washi Co’s treasury department to hedge the expected receipt using one of currency forwards, currency futures or exchange traded currency options. Washi Co’s treasury department has obtained the following information:

Annualised yield on short-dated Japanese treasury bills       1·20%
Airone’s annual inflation rate is 9% currently, but has fluctuated markedly in the last five years. The Japanese annual inflation rate is 1·5% and has been stable for many years.
Pato Bank has offered Washi Co the possibility of using over-the-counter options to hedge the EUR receipt instead of exchange traded currency options.

Airone project information
A member of Washi Co’s finance team has produced the following estimates of the Airone project which is expected to last for four years. The estimates are based on the notes given below but not on the further information. The estimates have been checked and verified independently for their numerical accuracy.

All figures are in ARD millions

Notes (incorporated into the estimates above):
1. The estimates are based on using the end of the first year, when the project commences, as the start of the project (year 0). The numbers are given in ARD million (m).

2. The total investment required for the project is ARD 10,150m and separated into buildings, machinery and working capital in the table above. The machinery is eligible for tax allowable depreciation on a straight-line basis and the working capital is redeemable at the end of the project.

3. The impact of inflation has been incorporated into the sales revenue and cost figures, at Airone’s current annual inflation figures.

4. Corporation tax has been included based on Airone’s annual rate of 15%. The tax is payable in the year that the tax liability arises.

Further information (not incorporated into the estimates above):
1. Undertaking the Airone project will result in lost sales for Washi Co. These sales would have generated a pre-tax contribution of JPY 110m in the first year of the project, rising by the Japanese rate of inflation in the following years 2 to 4 of the project.

2. The Airone project costs include components which are made in Japan by Washi Co and would be imported to the Airone project. The pre-inflation revenues generated from the sale of the components are estimated to be as follows:

In JPY millions

These revenues are expected to increase by the Japanese inflation rate in years 2 to 4 of the project. The contribution which Washi Co expects to earn on these components is 25% of revenue.

3. The Japanese annual corporation tax rate is 30% and tax is payable in the year that the tax liability arises. A bilateral tax treaty exists between Japan and Airone, which permits offset of overseas tax against any Japanese tax liability on overseas earnings.

4. Washi Co’s finance department has estimated a cost of capital of 12% to be used as a discount rate for the project.

(d) Washi Co’s chief operations officer (COO) has suggested that it would be more beneficial for the company to let its major subsidiary companies have their own individual treasury departments, instead of having one centralised treasury department for the whole company.

Required:
Discuss the validity of the COO’s suggestion. (7 marks)