Question

Carambola de Honduras. Slinger​ Wayne, a​ U.S.-based private equity​ firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 14 million Honduran lempiras​ (Lp) next​ year, and that this free cash flow will continue to grow at a constant rate of 6.5 % per annum indefinitely.

A private equity firm like Slinger​ Wayne, however, is not interested in owning a company for​ long, and plans to sell Carambola at the end of three years for approximately 10 times​ Carambola's free cash flow in that year. The current spot exchange rate is Lp14.2321​/$, but the Honduran inflation rate is expected to remain at a relatively high rate of 17.0​% per annum compared to the U.S. dollar inflation rate of only 3.0% per annum. Slinger Wayne expects to earn at least a 20.5% annual rate of return on international investments like Carambola.

a. What is Carambola worth if the Honduran lempira were to remain fixed over the​ three-year investment​ period?

b. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power​ parity?

a. Calculate the free cash flows in Honduran lempiras​ (Lp) below:  ​(Round to the nearest whole​ number.)

	Year 0		Year 1		Year 2		Year 3
Carambola's expected free cash flow		Lp	14,000,000	Lp		Lp
Expected sale value in year 3						Lp
Total expected cash flow		Lp		Lp		Lp
Expected exchange rate (Lp/$)	14.2321
Carambola's expected cash flow in US$

Answer 1

Free cash flow of years 2 and 3 are calculated at 6.5% higher of previous year.

Future exchange rate is calculated using the formula S*(1+iD)/(1+iF)

Where S= Spot rate, iD= inflation in domestic currency (Honduras, given as 17%) and iF= Inflation in US given as 3%)

a. Worth of Carambola if the Honduran lempira were to remain fixed over the​ three-year investment​ period = $8,552,227.18

b. Worth of Carambola if the Honduran lempira were to change in value over time according to purchasing power​ parity = $6,063,504.03

Calculation as follows: