In this assignment, you will simulate the effective tax rates and total net incomes of different intercompany transfer prices.
Green Light Trading is headquartered in the U.S. and its manufacturing facility is based in a foreign country. Green Light Trading sells toaster ovens at $20 per unit to customers in the U.S. and incurs unit selling expenses at $5 per unit. Green Light Trading sells 2.3 million units (Quantity) of toaster ovens per year. Its R&D expense is about $5.0 million per year and the amount of corporate expenses is $1.8 million per year. Green Light Trading, Co. currently only has manufacturing functions based in a foreign country (a subsidiary) while its sales, R&D, and headquarter functions are all based in the U.S. The foreign subsidiary’s total manufacturing cost per unit (COGS) is $3.5 and the cost of shipping (Shipping) the products from the foreign country to the U.S. is $0.75 per unit (recorded as the selling expenses of the foreign subsidiary). At the moment the U.S. parent company purchases finished products from the foreign subsidiary at a mark-up of one dollar per unit. The shipping cost from the foreign country to the U.S. is added to the purchase price paid by the U.S. and the price paid by the U.S. (the transfer price) is $5.75 ($3.5 + $0.75 + $1.5 = $5.75). The foreign subsidiary’s local general and administrative (Local Admin) expenses are $1.2 million per year. The corporate tax rate in the U.S. is 25% and the corporate tax rate in the foreign subsidiary is lower than the U.S. corporate tax rate.
Assume that you are an employee of Green Light Trading, Co. and you work for the tax director. Determine the transfer price, effective tax rates, gross margin, net profit margin, and pretax return on sales of the U.S. parent, the foreign subsidiary, and the consolidated level in the following scenarios: [Complete the Excel worksheet below by filling out the unknowns.]
Base case – The U.S. parent pays a $1.5 mark-up (10%)
Change the transfer price to the foreign subsidiary’s COGS (exclude shipping) plus 100% COGS, i.e., transfer price is 2*COGS per unit + shipping cost per unit (15%)
Change the transfer price to allow the foreign subsidiary to have 50% pre-tax return on sales (15%) Hint: the new transfer price (TP) can be determined by solving the following equation:
[ (TP-COGS- Shipping)×Quantity – Local Admin ]/(TP*Quantity) = 50%, solve for TP
The foreign subsidiary does half of the R&D work and incurs R&D expenses of $3.0 million ($5.0 million*50%). As a result, the foreign subsidiary is able to charge a $8 mark-up per unit. Although U.S. parent’s R&D expense is reduced by $2.5 million initially, the parent company incurs additional $100,000 R&D expense due to the overseeing activities needed (U.S. R&D is $5.0 million – $2.5 million + $100,000 = $2.6 million.) (15%)
U.S. parent manufactures domestically. In this scenario, the foreign subsidiary is dissolved. The U.S. cost of goods sold is estimated to be $10 per unit. In addition, the U.S. parent is able to reduce its headquarter expenses by $500,000. Selling expense and R&D expense are the same as in the base case. (15%)
Green Light Trading has two general managers whose bonuses may be affected depending on the scenario: the sales manager who is based in the U.S. and whose bonus is based on the level of gross margin; and the manufacturing manager who is based in the foreign country and whose bonus is based on the pre-tax return on sales. Assume that these two managers both aim to maximize their bonuses. Discuss ①which scenario (1 to 5 above) that you think will maximize Green Light Trading’s shareholder values, ②which scenario (1 to 5 above) that you expect each manager would prefer, and ③what are your suggestions on the necessary changes to the performance targets of each manager that would induce them to buy in the scenario that you suggest in ①? (20%)
Your deliverable is the Excel file for items 1 to 5 and a Word document for item 6 (at least half of a page). Please organize your Excel workbook in an understandable way with proper notations, and prepare the Word document free from grammatical errors. (10%)
Effective tax rate is tax expense dividend by operating income.
Net profit margin is the net income divided by sales revenue.
Pre-tax return on sales is operating income divided by sales revenue.
The Consolidation column is US + foreign – intercompany transactions. The foreign sub’s sales to the US will be eliminated during consolidation. Otherwise, the consolidated income statement will double-count the sales revenues.
For example, if US sales is $10 MM, and the foreign sub’s sales (to US) is $3 MM, then US’s COGS is the total transfer price paid by US to the foreign sub. US’s COGS and foreign sub’s sales revenue will be eliminated during consolidation. Therefore, in the consolidated column, there is only US’s sales revenue (to external customers) as the consolidated sales revenue, and foreign sub’s COGS as the consolidated COGS.
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