Assignment 2.2 (1)

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Simon Fraser University *

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Feb 20, 2024

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Special Topic in International Financial Management Assignment 2 – 10 Points The following questions are not necessarily related to one another. 1) The current spot rate is HUF250 / 1.00 USD. Long-run inflation in Hungary is estimated at 10 percent annually and 3 percent in the US. If PPP is expected to hold between the two countries, what spot exchange should one forecast five years into the future? 250*(1.1^5/1.03^5) = 347.31 (rounded) 5-year spot forecast: HUF 347.31/1 USD 2) The Delta Company, a US multinational company, is contemplating making a foreign capital expenditure in South Africa. The initial cost of the project is 10,000 ZAR. The annual cash flow over the five-year economic life of the project in ZAR are estimated to be: Year ZAR 1 3000 2 4000 3 5000 4 6000 5 7000 The parent firm’s cost of capital in USD is 9.5 percent. Long-run inflation is forecasted to be 3 percent annually in the US and 7 percent in South Africa. The current spot rate is 1.00 USD = 3.7500 ZAR. a. Determine the NPV for the project in USD by using PPP to forecast the exchange rates. Year 0: 10000/3.75 = -$2666.67 (rounded) Year 1: 3.75*(1.07^1/1.03^1) = 3.8956 (rounded) (3000/3.8956)/(1+9.5%)^1 = $703.29 Year 2: 3.75*(1.07^2/1.03^2) = 4.0469 (rounded) (4000/4.0469)/(1+9.5%)^2 = $824.35 Year 3: 3.75*(1.07^3/1.03^3) = 4.2041 (rounded) (5000/4.2041)/(1+9.5%)^3 = $905.85 Year 4: 3.75*(1.07^4/1.03^4) = 4.3673 (rounded) (6000/4.3673)/(1+9.5%)^4 = $955.61 Year 5: 3.75*(1.07^5/1.03^5) = 4.5370 (rounded) (7000/4.5370)/(1+9.5%)^5 = $980.07 NPV = -$2666.67 + $703.29 + $824.35 + $905.85 + $955.61 + $980.07 = $1702.5

b. What is the NPV in USD if the actual exchange rates are: S 0 = 3.7500 S 1 = 5.7000 S 2 = 6.7000 S 3 = 7.2000 S 4 = 7.7000 S 5 = 8.2000 Year 0: -$2666.67 Year 1: (3000/5.7)/(1+9.5%)^1 = $480.65 Year 2: (4000/6.7)/(1+9.5%)^2 = $497.92 Year 3: (5000/7.2)/(1+9.5%)^3 = $528.93 Year 4: (6000/7.7)/(1+9.5%)^4 = $542.01 Year 5: (7000/8.2)/(1+9.5%)^5 = $542.27 NPV = -$2666.67 + $480.65 + $497.92 + $528.93 + $542.01 + $542.27 = -$74.89 3) Dorchester Ltd. is a high-end confectioner located in the UK that sells internationally in Western Europe and North America (US and Canada). With its limited manufacturing facilities, however, it has only been able to supply the US more with a maximum of 225,000 pounds of candy per year. Dorchester believes that a separate manufacturing facility located in the US would allow it increase its supply quantity to both the US and Canada. The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount by a combination of equity capital and debt. The local community in which Dorchester has decided to build its facility will provide 1,500,000 USD of debt financing for a period of seven years. Both sales price and operating costs are expected to keep track with the U.S. price level. U.S. inflation is forecast at a rate of 3 percent for the next several years. In the U.K., long-run inflation is expected to be 4.5 percent. The current spot exchange rate is $1.5000/£1. Dorchester explicitly believes in PPP as the best means to forecast future exchange rates.

Dorchester’s CFM estimates, from the parent firm’s perspective, that the Present Value of the After-Tax Operating Cash Flow during the economic lifetime of the project will be 3,068,304 GBP. The Present Value of the Interest Tax Shields on the concession loan in the US and borrowing in the UK will be 84,351 GBP and 178,738 GBP, respectively (in total, 263,088 GBP). The Benefit from a Concession Loan in the US will be 43,856 GBP. a) The US IRS will allow Dorchester to depreciate the new facility over a seven-year period (straight-line depreciation), assuming a corporate tax rate of 35 percent and a discount rate (or interest rate) of 10.75 percent. Given the above information, calculate the Present Value of Depreciation Tax Shields. Facility cost = $7000000 Depreciation/Year = $7000000/7 = $1000000 1/$1.5 = 0.6667 Year 1 Spot: 0.6667*(1+4.5%)/(1+3%) = 0.6764 Year 2 Spot: 0.6667*(1+4.5%)^2/(1+3%)^2 = 0.6863 Year 3 Spot: 0.6667*(1+4.5%)^3/(1+3%)^3 = 0.6963 Year 4 Spot: 0.6667*(1+4.5%)^4/(1+3%)^4 = 0.7064 Year 5 Spot: 0.6667*(1+4.5%)^5/(1+3%)^5 = 0.7167 Year 6 Spot: 0.6667*(1+4.5%)^6/(1+3%)^6 = 0.7271 Year 7 Spot: 0.6667*(1+4.5%)^7/(1+3%)^7 = 0.7377 Year 1 Tax Shield: ($1000000*35%*0.6764)/(1+10.75%) = $213760.72 Year 2 Tax Shield: ($1000000*35%*0.6863)/(1+10.75%)^2 = $195836.92 Year 3 Tax Shield: ($1000000*35%*0.6963)/(1+10.75%)^3 = $179404.46 Year 4 Tax Shield: ($1000000*35%*0.7064)/(1+10.75%)^4 = $164340.19 Year 5 Tax Shield: ($1000000*35%*0.7167)/(1+10.75%)^5 = $150552.09 Year 6 Tax Shield: ($1000000*35%*0.7271)/(1+10.75%)^6 = $137911.28 Year 7 Tax Shield: ($1000000*35%*0.7377)/(1+10.75%)^7 = $126340.24 PV of the Tax Shields: $213760.72 + $195836.92 + $179404.46 + $164340.19 + $150552.09 + $137911.28 + $126340.24 = $1168145.90 b) Using the above Present Value calculations above and your results in (a), calculate

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the Adjusted Present Value (APV) of the project from the parent firm’s perspective. Should Dorchester build the new facility? c) Now calculate the Terminal Value (TV) of the project if the all-equity cost of capital for Dorchester is 15 percent. Does the Terminal Value change your investment decision from above? Hint: you are looking for the future value of the APV.