Your firm is considering an expansion project in Brazil that will result in annu

Question

Your firm is considering an expansion project in Brazil that will result in annual operating cash flows of BRL 35 million for 10 years. The initial cost of the project is USD 60 million. The project has no expected Salvage Value. Your company plans to fund the project with a combination of three sources of funding. Particulars follow:
• A loan from a Brazilian bank in the amount of BRL 100 million will obtained
• The loan will be retired by retaining BRL 20 million from the after-tax cash flows of the subsidiary in each of the 10 years
• The remainder will be funded by an equal proportion of US sourced debt and equity
• The S&P 500 is currently yielding 10%; Treasury Bills are currently yielding 2.5% and your firm’s Beta is 1.2
• Your firm’s bonds have an after-tax Yield to Maturity of 5.5%
• The current and expected exchange rate is BRL 3.5 / USD
IN USD - WHAT IS THE EXPECTED NPV OF THIS PROPOSED PROJECT?

Explanation / Answer

1.Calculation of Expected NPV of this proposed project in USD :

                              Initial Cash Outlay = $60 million

                            Exchange rate      = BRL 3.5/1 USD

       Funding from loan in Brazil in dollars    = $28.57 million (BRL 100/3.5)

          Remaining amount funded in equity = $15.715 million

                                        funded in debt     = $15.715 million

             Calculation of Discount rate :

                                        S&P 500 Current Average return = 10%

Firms beta given = 1.2

                             Treasury bills rate        = 2.5% (risk free rate)

                          Cost of equity using CAPM approach        = 2.5%+1.2(10%-2.5%)

                                                                                       = 11.5%

                                     Firm's Bond after tax interest rate = 5.5%

                                        since both debt and equity weights are same take 0.50 and 0.50

                                                                                       =11.5%*0.50+5.5%*0.50

                                                             Dicount rate =8.5%

               Calculation of Npv :

                                              Since annual operating cash flows are after deducting all expenses realted such income generation including interest on brazil loan and interest on debt raised in US (assumed).

                 Firm's annual after tax cash inflows           = $10 million (35/3.5)

               Cumulative PV factor for 8.5% for 10 years   = 6.5613

             present valule of total cash flow of the project = $65.6134

                Less: Initial cash outlay                              = $60.000

                                     Npv of the project               = $5.6134 million(Project should be accepted)

note:if we assume that interest on loan taken in brazil and interest on US debt was not deducted from annual operating cash flows given then we need to deduct $5.714 on account brazil loan and $0.86 on account of US debt from annual operating cash flow before applying discount factor.So that we will get negative Npv so project should not be accepted.

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