Question

Aunt Martha plans to invest in a project in Singapore. The project requires an initial investment of SGD500,000 and is expected to produce cash inflows of SGD169,000 a year for four years. The project will be worthless after four years. The expected inflation rate in Singapore is 2.1 percent while it is 1.4 percent in the U.S. The applicable interest rate in Singapore is 3 percent. The current spot rate is SGD1 = US$.75. What is the net present value of this project in U.S. dollars using the foreign currency approach? (Find the NPV in SGD, then convert to US$ using the spot rate)

Answer 1

Ques: Aunt Martha plans to invest in a project in Singapore. The project requires an initial investment of SGD 500,000 and is expected to produce cash inflows of SGD 169,000 a year for four years. The project will be worthless after four years. The expected inflation rate in Singapore is 2.1% while it is 1.4% in the U.S. The applicable interest rate in Singapore is 3%. The current spot rate is SGD1 = US$0.75. What is the net present values of this project in U.S. dollars using the foreign currency approach? (Find the NPV in SGD, the convert to US$ using the spot rate.)

Sol: Given question relates to International capital budgeting, to calculate NPV we be using Foreign currency approach. Foreign currency approach is where we calculate NPV in foreign currency and convert to local currency using spot rate.

Note:

(1) Terminal cash flows are zero, since project is worthless post year 4.

(2) Cost of capital would be applicable interest rate in foreign country plus nominal difference in inflation rates.

Cost of capital = 3% + (2.1% - 1.4%) = 3% + 0.7% = 3.7%

Thus, applicable cost of capital is 3.7%.

Year	0	1	2	3	4
Cash flows (a)	0	169,000	169,000	169,000	169,000
Add: Terminal cash flows (b)					0
Initial Investment (c)	(500,000)
Total Cashflows (d) = (a + b + c)	(500,000)	169,000	169,000	169,000	169,000
Discount Factor @3.7%	1/(1+0.037)^0	1/(1+0.037)^1	1/(1+0.037)^2	1/(1+0.037)^3	1/(1+0.037)^4
Discount factor (e)	1.0000	0.9643	0.9299	0.8967	0.8647
Present Values of cash flows (f) = (d * e)	(500,000)	162,970	157,155	151,548	146,140
Net Present Value (SGD) (g)	117,814
Spot rate (h)	0.75
Net Present Value (US$) (i) = (g * h)	88,361