Lakonishok Equipment has an investment opportunity in Europe. The project costs
ID: 2730154 • Letter: L
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
Calculation of Expected spot rates as per Interest rate parity theorem
Year
Current Rate
Calculation
Forward rate for an year
0
Euro 1 = $1.43
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.44
1
Euro 1 = $1.44
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.45
2
Euro 1 = $1.45
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.46
3
Euro 1 = $1.46
Cash flows in $ terms:
Year
Particulars
Euro terms
Exchange rate ($ per Euro)
Dollar terms
0
Cost of Project
15,000,000
1.43
21,450,000
1
Cash flow
2,800,000
1.44
4,032,000
2
Cash flow
3,400,000
1.45
4,930,000
3
Cash flow
3,900,000
1.46
5,694,000
3
Salvage value
9,800,000
1.46
14,308,000
Net present value of the project in $ terms
Year
Particulars
Cash Flow (in $)
Discounting Factor @11%
Discounted Cash flow (in $)
0
Cost of Project
(21,450,000)
1
(21,450,000)
1
Cash flow
4,032,000
0.90
3,628,800
2
Cash flow
4,930,000
0.81
3,993,300
3
Cash flow
5,694,000
0.73
4,156,620
3
Salvage value
14,308,000
0.73
10,444,840
Net Present Value
773,560
Year
Current Rate
Calculation
Forward rate for an year
0
Euro 1 = $1.43
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.44
1
Euro 1 = $1.44
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.45
2
Euro 1 = $1.45
Euro 1 = $1.43 * (1+2.9%)/(1+2.2%)
Euro 1 = $1.46
3
Euro 1 = $1.46
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