Question

MegaWash, Inc., is considering an expansion of their product line to Mexico. This would require a purchase of equipment with a price of 3,000,000MXN and additional installation of 500,000MXN, to be depreciated straight-line to zero over the 5-year life of the asset. They will not be replacing any existing equipment. Their required rate of return is 15% and they are in the 35% tax bracket. The new product line is expected to increase sales by 800,000MXN per year over current levels for the next 5 years, and expenses will increase by 400,000MXN. Assume the after-tax operating cash flows in years 1-5 are equal, and the terminal value of the project in year 5 may change total after-tax cash flows for that year. The equipment is multipurpose, and the company anticipates that they will sell it at the end of the five years for 600,000MXN. The initial investment also requires an increase in Net Working Capital (NWC) of 150,000MXN (to be recovered at the sale of the equipment at the end of five years). The current spot rate is $0.75/MXN, and the expected inflation rate in the U.S. is 3% per year and 2% per year in Mexico.

Question: What is the IRR of the MegaWash expansion?

Answer 1

MegaWash	0	1	2	3	4	5
USD/MXN	$             0.750	$      0.757	$      0.765	$         0.772	$      0.780	$      0.787
Investment	-3,500,000
NWC	-150,000					150,000
Salvage						600,000
Sales		800,000	800,000	800,000	800,000	800,000
Expenses		-400,000	-400,000	-400,000	-400,000	-400,000
Depreciation		-700,000	-700,000	-700,000	-700,000	-700,000
EBT		-300,000	-300,000	-300,000	-300,000	-300,000
Tax (35%)		105,000	105,000	105,000	105,000	105,000
Net Income		-195,000	-195,000	-195,000	-195,000	-195,000
CF (MXN)	-3,650,000	505,000	505,000	505,000	505,000	1,045,000
CF (USD)	-$2,737,500	$382,463	$386,213	$389,999	$393,823	$822,930
IRR	-4.06%

Forward exchange rate (USD/MXN) = Spot rate x (1 + US rate) / (1 + MX rate) = 0.750 x 1.03 / 1.02 = $0.757 / MXN and so on for other years

Depreciation = 3,500,000 / 5 = 700,000

CF (MXN) = Investment + NWC + Salvage x (1 - tax) + Net Income + Depreciation

CF (USD) = CF (MXN) x USD / MXN

IRR can be calculated using the same function on a calculator or excel given the cash flows.