Question

You are a senior financial analyst with IBM in their capital budgeting division. IBM is considering expanding in Australia due to its positive business atmosphere and cultural similarities to the U.S.

The new facility would require an initial investment in fixed assets of $5 billion Australian and an additional capital investment of 3% would be required each year in years 1–4. All capital investments would be depreciated straight-line over the five years that the facility operates. First-year revenues from the facility are expected to be $6 billion Australian and grow at 10% per year. Cost of goods sold would be 40% of revenue; the other operating expenses would amount to 12% of revenue. Net working capital requirements would be 11% of sales and would be required the year prior to the actual revenues. All net working capital would be recovered at the end of the fifth year. Assume that the tax rates are the same in the two countries, that the two markets are internationally integrated, and that the cash flow uncertainty of the project is uncorrelated with changes in the exchange rate. Your team manager wants you to determine the NPV of the project in U.S. dollars using a cost of capital of 12%.

1. Obtain exchange rates and comparable interest rates for Australia at Bloomberg’s Web site (www.bloomberg.com).
   1. Click “Currencies” from the quick menu. Copy the “AUD-USD” exchange rate (the U.S. dollars per Australian dollar) from the table and paste it into the same spreadsheet as the IBM Income Statement.
   2. Go to www.investing.com, click “Markets,” then “Bonds,” then click “World Government Bonds,” and select Australia from the drop down menu under “Find Government Bonds” to get the interest rates for Australia. Copy and paste the data into Excel.
   3. Now select “United States” from the drop down menu under “Find Government Bonds” to get the interest rates for the United States. Copy and paste the data into Excel.
2. You may have noticed that the four-year rate is not available at www.investing.com for the U.S. Treasury. To find an estimate of the four-year yield, calculate the average of the three- and five-year yields.
3. In your Excel spreadsheet, create a new worksheet with a timeline for the project expected cash flows.
   1. Use 20% as IBM’s effective tax rate.
   2. Determine the expected free cash flows of the project.
4. Note that the free cash flows you calculated in Question 4 are in Australian dollars. Use Eq. 30.3 to determine the forward exchange rates for each of the five years of the project. Then, use the forward rates to convert the cash flows to U.S. dollars.
5. Compute the NPV of the project in U.S. dollars using the 12% required return given by your team manager.

Answer 1

Computation of NPV in US dollars

Particulars	Year 0	Year 1	year 2	Year 3	Year 4	Year 5	Total
Investment in fixed asset	5000000000	150000000	150000000	150000000	150000000		5600000000
Revenues		6000000000	6600000000	7260000000	7986000000	8784600000
COGS		2400000000	2640000000	2904000000	3194400000	3513840000
Other operating expense		720000000	792000000	871200000	958320000	1054152000
Depreciation		1120000000	1120000000	1120000000	1120000000	1120000000
Net Income		1760000000	2048000000	2364800000	2713280000	3096608000
Tax on Net income(@20% on net income)		352000000	409600000	472960000	542656000	619321600
Net income after tax		1408000000	1638400000	1891840000	2170624000	2477286400
Add :- Depreciation (Being non cash expense)		1120000000	1120000000	1120000000	1120000000	1120000000
Cash flows after tax		2528000000	2758400000	3011840000	3290624000	3597286400
Net working capital	660000000
Recovery of working capital						660000000
Total capital investments= 5600000000
Depreciation over 5 years comes to
1120000000 per year
US dollars per Australian dollar	0.7142	0.7142	0.7142	0.7142	0.7142	0.7142
Cash flows after tax (in US dollars)		1805497600	1970049280	2151056128	2350163661	2569181947
Recovery of working capital (in US dollars)						471372000
Initial Investment in fixed asset	3571000000
Initial investment in working capital	471372000
PV facror at 12% discount rate		0.89285714	0.79719388	0.89285714	0.79719388	0.89285714
Present value of cash flows after tax		1612051429	1570511224	1920585829	1873536082	2293912453
Present value of recovery of working capital						420867857
Present Value of initial investment	4042372000
PV of total cash inflows		9691464873
PV of cash outflows		4042372000
NPV		5649092873