Question

FOREIGN CAPITAL BUDGETING Sandrine Machinery is a Swiss multinational manufacturing company. Currently, Sandrine’s financial planners are considering undertaking a 1-year project in the United States. The project’s expected dollar-denominated cash flows consist of an initial investment of $2,000 and a cash inflow the following year of $2,400. Sandrine estimates that its risk-adjusted cost of capital is 10%. Currently, 1 U.S. dollar will buy 0.96 Swiss franc. In addition, 1-year risk-free securities in the United States are yielding 3%, while similar securities in Switzerland are yielding 1.50%. a. If this project was instead undertaken by a similar U.S.-based company with the same risk-adjusted cost of capital, what would be the net present value and rate of return generated by this project? b. What is the expected forward exchange rate 1 year from now? c. If Sandrine undertakes the project, what is the net present value and rate of return of the project for Sandrine? below is the table given by instructor to use for this problems.

Class: A direct quote is the foreign exchange rate stated in terms of the domestic currency per unit of the foreign currency. In the U.S., a direct quote for the Canadian dollar would be US$0.82 = C$1. Conversely, in Canada, a direct quote for U.S. dollars would be C$1.22 = US$1.

Using the interest rate parity theorem, the one-period forward exchange rate is calculated using the spot rate (stated as a direct quote) and the interest rate forecasted for the two countries in the period ahead.

If the Japanese yen is the home currency and the U.S. dollar is the foreign currency and the one-year interest rate in Japan is 1% and in U.S. is 2%, the one-year forward exchange rate (direct quote) in Japan is given by

The spot rate (yen/$1) x [(1 + Japanese interest rate)/(1 + U.S. interest rate)]

If the spot rate is 100 yen/ US $ then we have 100yen/$1 x [(1+1%)/(1+2%)

= 100 x [(1.01)/(1.02)] = 100 x 0.9902 = 99.02 yen/$ 1

An initial investment in the U.S. of $100,000 = 100,000 x 100 yen = 10,000,000 yen

If the one-year cash inflow is $125,000

The yen equivalent is 125,000 x 99.02 = 12,377,500 yen

You can then calculate the NPV and rate of return with the information of cash outflows and inflows in yen.

Answer 1

a. If this project was instead undertaken by a similar U.S.-based company with the same risk-adjusted cost of capital, the net present value and rate of return generated by this project are as below:-

- NPV of the Project in $ = Present value of Cash Inflow at Year 1 @ Kc i,e 10% less Initial Outflow

= 2400/1.10 - 2000 = $ 181.81

- Rate of return= NPV/ Initial outflow= 181.81/2000 = 9.1%

b. The expected forward exchange rate 1 year from now:-

= Spot rate (per unit of $) * (1 + Interest rate in United State)/ (1 + Interest rate in Switzerland)

= 0.96*1.015/1.03 = Swiss franc 0.946 per unit of US dollar

c. If Sandrine undertakes the project, the net present value and rate of return of the project for Sandrine is as below:-

- NPV of the Project in Swiss franc = Present value of Cash Inflow at Year 1 @ Kc i,e 10% converted into Swiss franc using forward rate less Initial Outflow converted into Swiss franc using spot rate

= 2400*0.946/1.10 - 2000*0.96 = Swiss franc 144

- Rate of return= NPV/ Initial outflow= 144/2000*0.96 = 7.5%