Reference no: EM132529764

Elrond Corporation (EC), headquartered in Rivendell, manufactures state-of-the-art milling machines in Lothlorien in their Elven division. EC has two marketing subsidiaries, one in Erebor and one in Shireland, that sell its products. EC is building one new machine, at a cost of $500,000 at their Lothlorien subsidiary. There is no market for the equipment in Lothlorien. The equipment can be sold in Erebor for $1,000,000, but the Ereborian subsidiary would incur transportation and modification costs of $200,000. Alternatively, the equipment can be sold in Shireland for $950,000, but the Shireland subsidiary would incur transportation and modification costs of $250,000. The EC subsidiary located in Lothlorien can sell the equipment to either its Ereborian or its Shireland subsidiary, but not to both. All three subsidiaries of EC operate in a decentralized manner. Managers in each subsidiary have considerable autonomy, with managers interested in maximizing their own subsidiary's income.

REQUIRED

Question 1. From the viewpoint of EC and its subsidiaries taken together, should the Lothlorien subsidiary manufacture the equipment? If it does, where should it sell the equipment to maximize total corporate operating income? What would the operating income for EC and its subsidiaries be from the sale? Ignore any income tax effects.

Question 2. Assuming decentralization, what range of transfer prices will result in achieving the actions determined to be optimal in requirement l? Explain your answer.

Question 3. The effective income tax rates are as follows: 40% in Lothlorien, 60% in Erebor, and 15% in Shireland. The tax authorities in the three countries are uncertain about the cost of the intermediate product and will allow any transfer price between $500,000 and $700,000. If EC and its subsidiaries want to maximize after-tax operating income, (a) should the equipment be manufactured, and (b) where and at what price should it be transferred and sold?

Assume for your calculations that the headquarters in Rivendell and Lothlorien have the same tax rates. Show your computations.

Question 4. (a) Now suppose managers act autonomously to maximize their own subsidiary's after-tax operating income. The tax authorities will allow transfer prices only between $500,000 and $700,000. Which subsidiary will get the product and at what price? Explain your answer.

Question 4. (b) What alternative transfer pricing arrangement can EC consider that may be beneficial? Given the multinational nature of the supply chain, are there any drawbacks to the arrangement that you propose?