Assignment 4
On
International Corporate Finance
Week 16 ch 32
Lakonishok Equipment has an investment opportunity in Europe. The project costs €19 million
and is expected to produce cash flows of €3.6 million in year 1, €4.1 million in year 2, and €5.1
million in year 3. The current spot exchange rate is CDN$1.09/€, and the current risk-free rate in
Canada is 3.1 percent, compared to that in Europe of 2.9 percent. The appropriate discount rate
for the project is estimated to be 10.5 percent, the Canadian cost of capital for the company. In
addition, the subsidiary can be sold at the end of three years for an estimated €12.7 million. What
is the NPV of the project?
Answer
First, we need to forecast the future spot rate for each of the next three years. From interest rate and
purchasing power parity, the expected exchange rate is:
E(ST) = [(1 + RCAD) / (1 + RFC)]t S0
So:
E(S1) = (1.0310 / 1.0290)1 (CAD$1.09/€) = CAD$1.0921/€
E(S2) = (1.0310 / 1.0290)2 (CAD$1.09/€) = CAD$1.0942/€
E(S3) = (1.0310 / 1.0290)3 (CAD$1.09/€) = CAD$1.0964/€
Now we can use these future spot rates to find the dollar cash flows. The dollar cash flow each year
will be:
Year 0 cash flow = –€19,000,000(CAD$1.09/€)
= –CAD$20,710,000.00
Year 1 cash flow = €3,600,000(CAD$1.0921/€)
=
CAD$3,931,626.82
Year 2 cash flow = €4,100,000(CAD$1.0942/€)
=
CAD$4,486,389.09
Year 3 cash flow = (€5,100,000 + €12,700,000)(CAD$1.0964/€)
= CAD$19,515,351.22
And the NPV of the project will be:
NPV = –CAD$20,710,000 + CAD$3,931,626.82/1.105 + CAD$4,486,389.09/1.1052 +
CAD$19,515,351.22/1.1053
NPV = CAD$986,351.89
32.14 a. Implicitly, it is assumed that interest rates won’t change over the life of the project, but the
exchange
rate or the value of the dollar is projected to decline because the Euroswiss rate is lower than
the Eurodollar rate.
b. We can use uncovered interest rate parity to calculate the dollar cash flows at each time. The
equation is:
E[ST] = (SFr 1.72)[1 + (0.07 – 0.08)]T
E[ST] = 1.72(0.99)T
So, the cash flows each year in CAD dollar terms will be:
t
SFr
E[St]
CAD$
0
–25,000,000
1.7200
–14,534,883.72
1
7,200,000
1.7028
4,228,329.81
2
7,200,000
1.6858
4,271,040.21
3
7,200,000
1.6689
4,314,182.03
4
7,200,000
1.6522
4,357,759.63
5
7,200,000
1.6357
4,401,777.40
And the NPV is:
NPV=–CAD$14,534,883.72 + CAD$4,228,329.81/1.13 +
CAD$4,314,182.03/1.133
+ CAD$4,357,759.63/1.134 + CAD$4,401,777.40/1.135
CAD$4,271,040.21/1.132
+
NPV = CAD$603,600.61
c. Rearranging the uncovered interest rate parity equation to find the required return in Swiss francs,
we get:
RSFr = 1.13[1 + (0.07 – 0.08)] – 1
RSFr = 11.87%
So, the NPV in Swiss francs is:
5
NPV = –SFr 25,000,000 + SFr 7,200,000 A11.87%
NPV = SFr 1,038,193.05
Converting the NPV to dollars at the spot rate, we get the NPV in CAD$ as:
NPV = (SFr 1,038,193.05)(CAD$1/SFr 1.72)
NPV = CAD$603,600.61