Question

(a) Green Group reviews an invest opportunity in Australia. This is a two-year project and is expected to generate A$ 1,000,000 in the first year and A$ 2,000,000 in the second year. The group would have to invest US$ 1,500,000 in the project. The project’s cost of capital is 14% which is the same as the similar projects for Green Group. What is the net present value (NPV) of this project if the spot rate of the Australian dollar for the two years is forecasted to be $0.55 and $0.60, respectively?

(b) Green Group needs funding to finance the project in Australia. Comparing with other long-term financing means, the foreign currency bonds usually have lower yields. To determine the financing cost of the bond, suggest and describe any appropriate procedures

Answer 1

(a) The project cash flows are as below:

Year 0 (initial investment) = US$ 1,500,000

Year 1 = A$ 1,000,000; at the expected spot rate for Year 1 of 0.55US$, this will translate into (1000000 * 0.55) = US$ 550,000

Year 2 = A$ 2,000,000; at the expected spot rate for Year 1 of 0.55US$, this will translate into (2000000 * 0.6) = US$ 1,200,000

The cost of capital (discount rate) is given as 14%. Hence NPV of this project will be:

NPV = -1500000 + 550000/(1+14%) + 1200000/(1+14%)²? = - US$ 94,182.8 (negative NPV)

(b) The foreign currency bonds may have a lower currency but the effective cost could be different and will be impacted also by how the exchange rates move during the tenure of the loan. If a company resident in country A borrows in currency of country B due to lower rates in country B & converts the borrowed amount into currency A to use in business in country A, and during the tenure of the loan if the currency of country A depreciates then the amount to be paid back on maturity will increase by the percentage the currency of country A has depreciated . This can in effect change the cost of borrowing for the company and hence the company should always consider the exchange rates also when borrowing in foreign currency or they should look at total cost of borrowing by including the cost of hedge explicitly in the cost of borrowing to get a realistic cost.