Wujo is a Shanghai company that designs high- end software to enhance and edit digital images. Its software, EzPhoto, is more powerful and easier to use than Adobe Photoshop, but sells at a much lower price. Currently, EzPhoto is written in Chinese for the Chinese market, but Wujo is entering the English- speaking market. This requires a substantial investment to convert EzPhoto to English. Wujo has established a U. K. wholly owned subsidiary (Wujo U. K., or WUK for short) to sell EzPhoto to North American and European consumers— professional and serious amateur pho-to graphers. The following table displays the various combinations of prices and quantities it expects to sell EzPhoto to English- speaking users:
Price (euros) Quantity ( 000)
265 ......... 135
260 ......... 140
255 ......... 145
250 ......... 150
245 ......... 155
240 ......... 160
235 ......... 165
230 ......... 170
225 ......... 175
For example, at a price of € 270 it expects to sell 130,000 units of EzPhoto, or at € 225 it can sell 175,000 units. To enter this market WUK must spend € 15 million to convert EzPhoto from Chinese to English, advertise EzPhoto, establish a Web site where purchasers can download EzPhoto, and hire an administrative staff to market and maintain the Web site. For each English version of EzPhoto sold, WUK expects to incur costs of € 70 for sales commissions paid to third parties who market EzPhoto ( e. g., Amazon, ZDNet. com, and Buy. com) and technical support for customers pur-chasing EzPhoto. EzPhoto will be distributed only via the WUK Web site. There are no packaging or CD- ROM costs.
WUK is evaluated and its managers compensated based on reported WUK profits. Wujo China, the parent company, is considering charging WUK a transfer price (actually a royalty) for each unit of EzPhoto WUK sells.
a. If Wujo China does not charge WUK a royalty for each unit of EzPhoto WUK sells (i. e., the transfer price is zero), what price-quantity combination will WUK select and how much profit will WUK make?
b. If Wujo China charges WUK a royalty of € 50 for each unit of EzPhoto WUK sells ( i. e., the transfer price is € 50), what price- quantity combination will WUK select and how much profit will WUK make?
c. Ignoring any income taxes, what is the firm- value maximizing royalty (either zero euros or € 50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Explain your answer.
d. Wujo (the parent) has to pay income taxes to the People’s Republic of China (PRC) at the rate of 15 percent on any royalty payments it receives from WUK, while WUK faces a U. K. tax rate of 33 percent on profits of EzPhoto. What is the firm-value maximizing royalty (either zero euros or € 50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Whichever transfer price Wujo charges WUK (zero or € 50), that transfer price is used to (1) measure and reward WUK managers, and (2) calculate income taxes in the PRC and the U. K. Provide a detailed explanation supported by calculations justifying your answer. e. Suppose that Wujo is able to use a different transfer price for determining WUK’s profits ( and hence the compensation paid to WUK management) than it uses for calculating income taxes on its PRC and U. K. tax returns. What transfer prices should Wujo use for calculating WUK’s net income in determining WUK’s managers’ bonuses and for use on its two tax returns? The same transfer price has to be used on the two tax returns, but this transfer price need not be the same transfer price used for calculating WUK’s income for management bonuses.
f. Why might you expect Wujo will be unable to implement the two transfer prices you propose in (e)?