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In: Finance

4. Wilmington Inc. is considering the acquisition of a unit from the French government. • Initial...

4. Wilmington Inc. is considering the acquisition of a unit from the French government.

• Initial outlay will be $4 million dollars

• All earnings reinvested

• Time period 8 years and at that time will sell acquisition for 12 million euros after taxes

• Spot rate for euro is $1.20

• Risk free U.S. intersect rate regardless of maturity is 5 percent

• Risk free interest rate on euros regardless of maturity is 7 percent

• Interest rate parity holds

• Cost of capital is 20 percent

• Cash will be used for acquisition

a. Using the parameters above, Determine the NPV.

b. Rather than use all cash, Wilmington Inc. could partially finance the acquisition. It could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the loan. There are no interest payments on this debt. This financing deal is structured such that none of the payment is tax-deductible. Determine the NPV if Wilmington uses the forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to partially finance the acquisition.

Solutions

Expert Solution

Year 0 8
Rate $1.20 $   1.032
Cash Flows -$     4.00 €   12.00
CF ($) -$     4.00 $   12.38
NPV ($) -$     1.12

Let's forecast the exchange rate in 8 years using interest rate parity

Future Rate = Spot Rate x ((1 + US rate) / (1 + euro rate))^n = 1.20 x (1.05 / 1.07)^8 = 1.032 dollar per euro

Cash Flows in dollars after 8 years = 12 x 1.032 = 12.38

NPV = 12.38 / (1 + 20%)^8 - 4 = - $ 1.12 million

b)

Year 0 8
Rate $1.20 $   1.032
Loan €     3.00 €     7.00
Cash Flows -$     4.00 €   12.00
Net CF ($) -$     0.40 $     5.16
NPV ($) $     0.80

In this case, net cash flow in year 0 = -4 + 3 x 1.2 = -0.40 million

Net cash flow in year 8 = 1.032 x (12 - 7) = $5.16 million

NPV = 5.16 / (1 + 20%)^8 - 0.40 = $0.80 million

jeff jeffy answered 3 years ago
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