Lakonishok Equipment has an investment opportunity in Europe. The project costs
ID: 2730488 • Letter: L
Question
Lakonishok Equipment has an investment opportunity in Europe. The project costs €13 million and is expected to produce cash flows of €2.6 million in Year 1, €3.2 million in Year 2, and €3.7 million in Year 3. The current spot exchange rate is $1.41 / €; and the current risk-free rate in the United States is 2.7 percent, compared to that in Europe of 2 percent. The appropriate discount rate for the project is estimated to be 14 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 €8.6 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
Using interest rate parity:-
Expected spot rate for Year 1 = 1.41 * (1 + 0.027) / (1 + 0.02)
= 1.41 * 1.027 / 1.02
= $ 1.42 (approx)
Expected spot rate for Year 2 = 1.42 * 1.027 / 1.02
= $ 1.43 (approx)
Expected spot rate for Year 3 = 1.43 * 1.027 / 1.02
= $ 1.44 (approx)
P.V. of cash outflow (Project cost in U.S. Dollars) = 13 * 1.41 = $ 18.33 Milion.
P.V. of Cash inflow (In U.S. dollars) = 2.6 * Spot rate at end of year 1 * P.V. factor for first year @ 14 % + 3.2 * Spot rate at end of year 2 * P.V. factor for second year @ 14 % + 3.7 * Spot rate at end of year 3 * P.V. factor for third year @ 14 %.
= 2.6 * 1.42 * 0.877 + 3.2 * 1.43 * 0.769 + 3.7 * 1.44 * 0.675
=$ 10.35 Million
Total P.V. of cash inflow including present value of sale value of subsidiary company at end of year 3:-
= 10.35 + 8.6 * 1.44 * 0.675
= 10.35 + 8.3592
= $ 18.7092 Million
NPV of Project in U.S. Dollars: = 18.7092 - 18.33 = 0.3792 Million dollars
Conclusion: The NPV of project in U.S. dollars = $ 0.3792 Million.
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