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Question 1 Delta Company, a U.S. MNC is contemplating making a foreign capital expenditure in Mexico....

Question 1

Delta Company, a U.S. MNC is contemplating making a foreign capital expenditure in Mexico. The initial cost of the project is MP 28,000. The annual cash flows over the five-year economic life of the project in MP are estimated to be 5,000, 6,000, 8,000, 9,000 and 9,800. The parent company’s cost of capital is dollars is 6.5%. Long-run inflation is forecasted to be 3% per annum in the U.S. and 4.5% in Mexico. The current spot rate is MP/USD = 19.45. Determine the following things:

  1. Calculating the NPV in MP using the MP equivalent cost of capital according to fisher effect and then converting to USD at the current spot rate.

  1. Converting all the cash flows from MP to USD at purchasing power parity forecasted exchange rates and then calculating the NPV at the dollar cost of capital.

  1. Are the two dollar NPV different or the same? Explain.

  1. What is the NPV in dollars if the actual pattern of ZAR/USD exchange rate is:

Year 0: MP/USD = 19.45

Year 1 : MP/USD = 21.20

Year 2 : MP/USD = 22.15

Year 3 : MP/USD = 23.63

Year 4 : MP/USD = 24.32

Year 5 : MP/USD = 25.19

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Answer #1

a. As per fisher effect, MP equivalent cost of capital = (1+US cost of capital)*(1+Mexico inflation rate)/(1+US inflation rate)

= (1+6.5%)*(1+4.5%)/(1+3%)

= 8.051%

Using the above cost of capital, calculating PV for all years using the formula PV = FV/(1+R%)^N

Year Cashflows PV of cash flows (at MP cost of capital) PV of cash flows (at MP cost of capital) converted to USD at spot rate (A) PV of cashflows with PPP EXCHANGE RATES (B) PV of cashflows at provided rates (D)
Year 0 -28000 -28000 -1439.588689 -1439.588689 -1439.588689
Year 1 5000 4627.445695 237.9149458 237.9149458 221.4545132
Year 2 6000 5139.180878 264.225238 264.225238 238.8241849
Year 3 8000 6341.674781 326.0501173 326.0501173 280.2705347
Year 4 9000 6602.795025 339.4753226 339.4753226 287.6606833
Year 5 9800 6653.998645 342.1078995 342.1078995 283.9552282
NPV(MP) 1365.095025
NPV(USD) 70.18483417 70.18483417 -127.4235446

So NPV(MP) = 1365.095

Converting this to USD at spot rate, NPV = $70.185

(b) CALCULATION of purchasing power parity exchange rates

Puchasing power parity exchange rate (MP/USD) = spot rate *[(1+ Mexico inflation rate)/(1+ US inflation rate)]^t

Calculating for all years, below are the PPP exchange rates

MP/USD (1) 19.73325243
MP/USD (2) 20.02062989
MP/USD (3) 20.31219246
MP/USD (4) 20.60800109
MP/USD (5) 20.90811761

Using the above rates, if you calculate the PV of cash flows in USD,

Year Cashflows PV of cashflows with PPP EXCHANGE RATES
Year 0 -28000 -1439.588689
Year 1 5000 237.9149458
Year 2 6000 264.225238
Year 3 8000 326.0501173
Year 4 9000 339.4753226
Year 5 9800 342.1078995
NPV(MP)
NPV(USD) 70.18483417

(c) So both NPVs are the same. This is because of the fact that fisher effect and PPP concepts hold good and we have accounted both counties'inflation rates in the calculations.

(d)Using the PROVIDED rates, if you calculate the PV of cash flows in USD,

Year Cashflows PV of cashflows at provided rates
Year 0 -28000 -1439.588689
Year 1 5000 221.4545132
Year 2 6000 238.8241849
Year 3 8000 280.2705347
Year 4 9000 287.6606833
Year 5 9800 283.9552282
NPV(MP)
NPV(USD) -127.4235446

NPV is negative at -$127.42, as the actual rates dont follow the PPP rates trend

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