Lakonishok Equipment has an investment opportunity in Europe. The project costs

Question

Lakonishok Equipment has an investment opportunity in Europe. The project costs €15 million and is expected to produce cash flows of €2.8 million in Year 1, €3.4 million in Year 2, and €3.9 million in Year 3. The current spot exchange rate is $1.43 / €; and the current risk-free rate in the United States is 2.9 percent, compared to that in Europe of 2.2 percent. The appropriate discount rate for the project is estimated to be 11 percent, the U.S. cost of capital for the company. In addition, the subsidiary can be sold at the end of three years for an estimated €9.8 million. Use the exact form of interest rate parity in calculating the expected spot rates. What is the NPV of the project in U.S. dollars? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16. Enter your answer in dollars, not in millions, e.g., 1,234,567.) NPV $

Explanation / Answer

Step 1: Compute Expected spot rates for the year 1,2, and 3 by using Interest Rate Parity Theory

  Interest Rate Parity Theory is (1+Rh)(1+Rf)=F1/So

Where, Rh =interest rate in home country i.e, 2.9% in USA

Rf =interest rate in Foreing country i.e, 2.2% in Europe

F1 =Forward rate ,So = Spot rate i.e, $ 1.43/€

Then , Spot rate for the year 1 =(1+.029)/(1+.022)=F/1.43

Spot rate for the year1 =$ 1.44/€

Spot rate for the year 2 =(1+.029)/(1+.022)=F/1.44

Spot rate for the year 2 =$ 1.45/€

Spot rate for the year 3 =(1+.029)/(1+.022)=F/1.45

Spot rate for the year 2 =$ 1.46/€

Step: 2 Convert european currency into us dollars bu using above computed expected spot rates

(in millions ) Year Cash flows(european currency) Exchange rate($/€ Cash flows in Us dollars PVF@11% PV 0 -15 1.43 -21.45 1 -21.450 1 2.8 1.44 4.032 0.901 3.632 2 3.4 1.45 4.93 0.812 4.001 3 3.9 1.46 5.694 0.731 4.163 3 9.8 1.46 14.308 0.731 10.462 Net present value(in dollars) $ 0.809

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