How do international factors affect decision making? Although the same basic pri

Question

How do international factors affect decision making? Although the same basic principles of capital budgeting apply to both foreign and domestic operations, there are some key differences. For example, cash flows must be converted into the parent company's currency, so they are subject to exchange rate risk. In addition, the cost of capital may be different for a foreign project compared with an equivalent domestic project.

For this Assignment, complete Problem 19-17, Parts a, b, and c on page 680 of your course text. This case examines the effects of exchange rates on net present values and rates of return.

In addition to solving for the rates of return from the U.S. and Swiss points of view, write a paragraph that summarizes your key learning points from this case. Be sure to include your calculations as an appendix.

Submit your Assignment (both your Excel and Word files).

General Guidance on Application Length:

Your Assignment, due by Day 7, will typically be 2–3 pages in length as a general expectation/estimate. Refer to the rubric for the Week 7 Assignment for grading elements and criteria. Your Instructor will use the rubric to assess your work.

19-17 FOREIGN CAPITAL BUDGETING ing company. Currently, Solitaire's financial planners are considering undertaking a 1-year project in the United States. The project's expected dollar-denominated cash flows consist of an initial investment of $1,000 and a cash inflow the following year of $1,200. Solitaire estimates that its risk-adjusted cost of capital is 12% Currently, 1 US dollar will buy 0.90 Swiss franc. In addition, 1-year risk-free securities in the United States are yielding 5%, while similar securities in Switzerland are yielding 3.25%. Solitaire Machinery is a Swiss multinational manufactur- a. If this project was instead undertaken by a similar U.S.-based company with the same risk-adjusted cost of capital, what would be the net present value and rate of return generated by this project? b. What is the expected forward exchange rate 1 year from now? c. If Solitaire undertakes the project, what is the net present value and rate of return of the project for Solitaire?

Explanation / Answer

a. NPV and IRR if Project is undertaken by US Firm:-

Cash Outflow = $ 1000 -------(i)

Present Value of Cash Inflow = $1200 * 1/(1+0.12)^1

= 1200 * 0.8929

PV of Cash Inflow = 1071.48 -------------(ii)

NPV = (ii)-(i) --- 1071.48-1000 = $71.48

IRR

By Using Trial and Error

At IRR PV of Cash Outflow = PV of Cash Inflow (in $)

Hence the IRR = 20%

So for US Firm

NPV = $ 71.48 and IRR = 20%.

b. Expected Forward rate for 1 year :-

Using Interest Rate Parity Principle

= 0.90 * [(1+0.05)/(1+0.0325)]

= 0.90 * 1.017

Expected Forward Rate -- $1 = SF 0.9153

c. NPV & IRR of Project if Solitaire has taken up the project :-

Since Solitaire has known that it will Recive $ 1200 in one year. So it take forward selling contract at SF0.91.

The Firm will receive SF = 1200/0.91 = 1318.68

Also firm has to invest $ 1000 so amount of investment in SF = $1000/0.90 = SF1111.11

Hence PV of Cash Outflow = SF 1111.11-----------(i)

PV of Cash Inflow = 1318.68*1/(1+0.12)^1   

= 1318.68 * 0.8929

PV of Cash Inflow  = 1177.45--------(ii)

NPV =(ii)-(i)------- 1177.45-1111.11 = 66.34

NPV = SF 66.34

IRR of Project :-

By using Trail and Error (in SF)

We want to reduce NPV by only 36.14 by increasing the Discount rate.

a 1% increase in rate decrease the NPV by 39.16 (36.14-(-3.02))

hence for decrease of 36.14 in NPV a discount rate should increase by = (36.14*1)/39.16

= 0.92

Hence the IRR = 18 + 0.92 = 18.92%.

For Solitaire the NPV and IRR of Project :-

NPV = SF 66.34 and IRR = 18.92%.

Year Cash Flow DF @15% PV DF@20% PV 0 -1000 1 -1000 1 -1000 1 1200 0.87 1044 0.8333333 999.96 NPV 44 0

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