Question

Mill Company is evaluating the proposed acquisition of a new milling machine. The machine's base price
is $140,000, and has a terminal value of $17,000. The company's cost of capital is 6%. The project has a
life-time of 3 years. The operating cash flows are as follows:

	YEAR 1	YEAR 2	YEAR 3
After-tax Savings	$28,000	$25,500	$25,000
Depreciation tax savings	$12,000	$15.500	$10,200
Net cash flow	$40,000	$41,000	$35,200

(a) Find the net present value of this project (NPV). Should it be accepted?

Suppose Mill Company wishes to expand its operations in the UK. The exchange rate at the time of
investment is £1= $1.6.
(b) Use the PPP to find the exchange rate 1 year from now, 2 years from now and 3 years from now. The
inflation rate in the U.S. (?$) is 3 percent and in the UK 2 percent (?£)
(c) Find the NPV in pounds. Should Mill Company invest in the UK?

Answer 1

Year	CF ($)	Exchange	CF (£)
0	-140,000	$   1.600	-£     87,500
1	40,000	$   1.616	£      24,757
2	41,000	$   1.632	£      25,130
3	52,200	$   1.648	£      31,684
NPV	-$21,946.17	NPV	-£15,176.15

In the last year, we add the terminal cash flows to the net cash flow.

NPV = -CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + CF3 / (1 + r)^3

= -140,000 + 40,000 / 1.06 + 41,000 / 1.06^2 + 52,200 / 1.06^3

= -21,946.17

Forecast exchange rate using PPP equation.

Future Rate = Current Rate x (1 + US rate) / (1 + UK rate) = 1.6 x 1.03 / 1.02 = 1.616 dollar per pound and so on..

Convert the dollar cash flows into pound cash flows by dividing them with the exchange rate.

NPV (pound) = - 87,500 + 24,757 / 1.06 + 25,130 / 1.06^2 + 31,684 / 1.06^3 = -15,176.15

As NPV < 0, the company should not invest.