A French firm is considering a one-year investment in the United Kingdom with a

Question

A French firm is considering a one-year investment in the United Kingdom with a pound-denominated rate of return of i£ = 15%. The firm's local cost of capital is i€ = 10%. The project costs £1,000 and will return £1,150 at the end of one year. The current exchange rate is €2.00 = £1.00. Suppose that the bank of England is considering either tightening or loosening its monetary policy. It is widely believed that in one year there are only two possibilities: S1 (€|£) = €2.20 per £ S1 (€|£) = €1.80 per £ Following revaluation, the exchange rate is expected to remain steady for at least another year. Find the ex post IRR in euro for the French firm if they undertake the project today and then the exchange rate falls to S1(€|£) = €1.80 per £.

Explanation / Answer

Cash Flow at Time 0 (in terms of euro) = £1,000 x €2/£1 = €2,000

If exchange rate falls to €1.80 per £ in 1 year

Cash Flow at Time 1 (in terms of euro) = £1,150 x €1.80/£1 = €2,070

IRR is the rate at which NPV is zero, or when PV of Cash outlows is equal to PV of cash inflows

Hence,

2000/(1 + r)0 = 2070/(1+r)1

1+r = 2070/2000

r = 1.035 - 1

r = 0.035 or 3.5%

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