Halstow Co is a listed manufacturer of kitchen appliances whose currency is the dollar ($). It owns all the shares of Merrick Co, which makes electric motors in a country whose currency is the euro (EUR) and sells its whole output to Halstow Co. The board of Halstow Co meets next month to set next year's dividend. The finance director has proposed raising the dividend by 5$12.0m paid this year to $12.6m, and the group tax manager has proposed raising the price Merrick Co charges for its motors. You are a financial adviser to the board.

Exhibit 1: Merrick Co. Merrick Co forecasts profit before tax of EUR 8.0m next year at the current transfer price, taxed locally at 20%. Its government allows dividends to be paid abroad only up to 75% of each year's profit after tax, and Merrick Co will pay that maximum to Halstow Co next year. Withholding tax of 10% is deducted from dividends paid abroad. Halstow Co's country does not tax dividends received from foreign subsidiaries. The dividend is received next year; convert it at the forecast rate of EUR 0.8800 = 1. Exhibit 2: Halstow Co's own forecasts for next year, excluding any dividend from Merrick Co, are in the table. Halstow Co measures its dividend capacity as its free cash flow to equity, plus dividends received from Merrick Co, less cash it has committed to other uses. The share repurchase has been announced and will not be repeated. In the following year the capital investment programme rises to $22.0m; Halstow Co's other forecasts, and the dividend from Merrick Co, are expected to stay at next year's levels. Exhibit 3: Transfer price. Merrick Co sells 500,000 motors a year to Halstow Co at $40 each, invoiced in. The tax manager proposes 44 a motor, the top of the range of $36 to $44 that independent motor makers have quoted to Halstow Co. Halstow Co's country taxes company profits at 30% and charges import duty of 5% of the transfer price, which is deductible for tax. For the transfer price, take every effect in, with Merrick Co's tax at 20% of the change in its profit. The tax manager says the change "saves tax with no other effect on the group".