Tailor Johnson, the menswear company with a subsidiary in Ethiopia described in Problem 13 is considering the tax benefits resulting from deferring repatriation of the earnings from the subsidiary. Under U.S. tax law, the U.S. tax liability is not incurred until the profits are brought back home. Tailor Johnson reasonably expects to defer repatriation for 10 years, at which point the ETB earnings will be converted into USD at the prevailing spot rate, S10, and the tax credit for Ethiopian taxes paid will still be converted at the current exchange rate = 0.125 USD/ETB. Tailor Johnson’s after-tax cost of debt is 5%.
a. Suppose the exchange rate in 10 years is identical to this year’s exchange rate, so S10 = 0.125 USD/ETB. What is the present value of deferring the U.S. tax liability on Tailor Johnson’s Ethiopian earnings for 10 years?
b. How will the exchange rate in 10 years affect the actual amount of the U.S. tax liability? Write an equation for the U.S. tax liability as a function of the exchange rate S10.
