Question

1. Widgets International’s British factory cost £100 million, which also the market value of the pound debt financing it. WI is expecting net pound revenues of £15 million pounds per year forever from British sales of widgets, not counting year 0. It forecasts the future $/£ exchange rate as equal to the current spot rate, which is currently 2 $/£. WI’s dollar discount rate is 12% per year.

a) What is the net present value of WI’s British subsidiary?

b) How would it change if the pound depreciated 20%, to 1.60 $/£? Remember to take into account the depreciation’s impact on the dollar value of the pound debt.

c) How would the NPV change following a 20% pound depreciation if WI had used $200 million worth of dollardebt to finance the subsidiary, rather than pound debt?

d) How would a 20% pound depreciation affect WI’s balance sheet under FASB 52 if it has issued pound debt? If it has issued dollar debt?

Answer 1

Solution:

Dollar Discount rate = 12%

Future spot rate = Current spot rate

We have to convert all the cashflow to $ then discount to find the NPV.

Exchange rate = 2 $/£

Initial cost = £100 million =  £100 million *2 $/£ = $200 million

Net pound revenue = £15 million * 2 $/£ = $30 million

The time period is forever hence

NPV = -$200 million + 30 miilion /0.12 = -200 + 250 = $50 million

Part B )

Exchange rate = 1.6 $/£

Initial cost = £100 million =  £100 million *1.6 $/£ = $160 million

Net pound revenue = £15 million * 1.6 $/£ = $24 million

The time period is forever hence

NPV = -$160 million + 24 miilion /0.12 = -160 +200 = $40 million

Part C )

Here initial investment = $200 million

NPV = -$200 million + 24 miilion /0.12 = -200 +200 = $0 million

Part D) When debt are issued in pound and the pound depreciates then there will be translational gain due to depreciation as the debt in the balance sheet was £100 million and when we convert this to USD then it will become $160 million. $40 million will be translational gain