Question

Mf  Limited, a bespoke furniture manufacturing entity based in South Africa, is looking to diversify its market by entering the European and American markets.

In order to gain a foothold in the new markets, Mf Limited can either produce the furniture in South Africa and export it, or acquire existing businesses in Europe and America. In order to decide between these two options, the company engaged an international consultancy firm at a cost of R800 000.

Research by the consultancy firm suggested that the export route was less risky, especially considering the company’s plans to try out the international market for an initial five-year period before making a longer-term decision. In order to export the furniture, the company will need to ramp up production in South Africa.

This will need the company to expand its production capacity through building a new factory and acquiring new machinery. Construction of the factory will cost the company R18 million while the new machinery will cost the company R6.5 million to purchase and R500 000 to transport and install. The company expects additional after-tax operating cash flows from the new markets to be R6 million per annum, stated in current prices.

The cash flows are expected to increase in line with inflation. The expected annual inflation rate is 6%. The factory and machinery are expected to have after-tax salvage values of R10 million and R1 million, respectively (stated in current prices). The company’s nominal cost of capital is 12%.

Calculate the net present value (NPV) and internal rate of return (IRR) of the expansion project TO SHOW IF EXPANSION PROJECT IS VALID, TO WHAT TYPES OF EXCHANGE RATE RISK WILL HE BE EXPOSED

Answer 1

Inflation rate (%)	6%
	Year0	Year1	Year2	Year3	Year4	Year5
Cosntruction cost	-18
Machine cost	-6.5
Transportation cost	-0.5
Operating cash flows		6.0	6.4	6.7	7.1	7.6
Factory Salvage value						10.0
Machine Salvage value					1
Net cash flows	-25.0	6.0	6.4	6.7	7.1	18.6
IRR	19%
NPV @12%	5.31

The above table gives the case facts along with the IRR and NPV calculations.

As per the NPV and IRR of the project the expansion project is valid and the company should undertake it.

The company will experience a foreign exchange risk because the total sales amount has to be converted to the country's currency. If the domestic currency strenghtens against the foreign curreny, in this case european and american currenncies, then the value of thier sales in local currency i.e South African currency will be lower and they will incur a curreny translation loss.

Please reach out for any further clarifications.