Question

In a bid to gain greater acceptance in Asian markets, Wide Bay Cookies Ltd is evaluating an opportunity to produce and distribute its products from a new manufacturing plant in Vietnam. Wide Bay will invest AUD $3,000,000 to set up the factory and provide working capital for operations. AUD $2,000,000 of this initial outlay will be recovered when the project is terminated in four years’ time. Wide Bay expect to receive 13,000,000,000 Vietnamese Dong (VND) after tax for each of the four years of operation. The current spot rate is AUD VND 15 746.72.

The risk free rate in Australia is 1% while it is 4.45% in Vietnam. You should assume that interest rate parity exists. Wide Bay Cookies works on the assumptions that the one year forward rate predicts the spot rate in one years’ time and that the change in the exchange rate in the first year will be repeated for each year of the project. Wide Bay’s annual required return for the project is 12%.

Rice Paper Ltd is an Australian company that imports Vietnamese products. Rice Paper’s contracts are written in Vietnamese Dong and they agree to take 13,000,000,000 each year from Wide Bay Cookies at the rate of AUD VND 14 000.

a) Ignoring any tax implications, what is the net present value of the project for Wide Bay Cookies if it does not hedge the project’s cash flows?

b) Ignoring any tax implications, what is the net present value of the project for Wide Bay Cookies if it engages in the currency swap?

c) Should Wide Bay undertake the project? Justify your answer.

Answer 1

Initial cash outflow = AUD$ 3,000,000

Amount to be recovered at end of period = AUD$2,000,000

Project time = 4 years

a) NPV for wide bay cookies if it does not hedge

Calculation of forward interest rate

AUDVND = 15,746.72

R_{f (Australia)} = 1%

R_{f (Vietnam)} = 4.45%

Under interest rate parity theory:

Forward rate = Spot rate x (1+i_Australia) / (1+i_Vietnam)

F = 15,746.72 x (1+0.01)/(1+0.0445)

F₁ = 15,746.72 x 0.96696 = 15,226.60 .......... (Forward rate in year 1 which will be equal to spot rate after 1 year)

As mentioned the change in exchange rate will be repeated. So,

F₂ = 15,226.60 x 0.96696 = 14,723.51

F₃ = 14,723.51 x 0.96696 = 14,237.05

F₄ = 14,237.05 x 0.96696 = 13,766.66

Calculating NPV

	Year 0	year 1	Year 2	Year 3	Year 4
outlay (AUD)	-3,000000
Cash inflow (VND) {A}		13,000,000,000	13,000,000,000	13,000,000,000	13,000,000,000
Exchange rate as calculated {B}		15,226.60	14,723.51	14,237.05	13,766.66
Cash inflow (AUD) {C=A/B}		853,769.06	882,941.64	913,110.51	944,310.38
Cash inflow at year 4 (AUD) {D}					2,000,000
Discount rate at 12% {E}		1/1.12=0.8929	1/(1.12)2=0.7972	1/(1.12)3=0.7118	1/(1.12)4=0.6355
Present Value {F=[C+D]xE except year 0}	-3,000,000	762,330.39	703,881.08	649,952.06	1,871,109.25
Net Present Value (Row F year 0+1+2+3+4)	987,272.78

Hence NPV for the project is AUD$ 987,272.78 which is greater than zero. So the company could accept the project

b) NPV for wide bay cookies if engaged in currency swap

	Year 0	year 1	Year 2	Year 3	Year 4
outlay (AUD)	-3,000000
Cash inflow (VND) {A}		13,000,000,000	13,000,000,000	13,000,000,000	13,000,000,000
Exchange rate {B}*		14,000	14,000	14,000	14,000
Cash inflow (AUD) {C=A/B}		928,571.43	928,571.43	928,571.43	928,571.43
Cash inflow at year 4 (AUD) {D}					2,000,000
Discount rate at 12% {E}		1/1.12=0.8929	1/(1.12)2=0.7972	1/(1.12)3=0.7118	1/(1.12)4=0.6355
Present Value {F=[C+D]xE except year 0}	-3,000,000	829,121.43	740,257.14	660,957.14	1,861,107.14
Net Present Value (Row F year 0+1+2+3+4)	1,091,442.85

*Row B has constant exchange rate for the forward years as the company engages in currency swap

Hence NPV for the project is AUD$ 1,091,442.85 which is greater than zero. So the company could accept the project

C) Should the company undertake the project

In both the cases without hedge and currency swap, the company Wide bay cookies ltd can undertake the project as the NPV for the project is greater than zero