17-14Foreign Capital Budgeting The South Korean multinational manufactoring firm

Question

17-14Foreign Capital Budgeting

The South Korean multinational manufactoring firm, Nam Sung Industries is debating whether to invest in a 2 year project in the United States. The project's expected dollar cash flows consist of an initial investment of $1 million with cash inflows of $700,000 in year 1 and $600,000 in year 2. The risk adjusted cost of capital for the project is 13%. The current exchange rate is 1,050 won per per US dollar. Risk free interest rates in the united states and South Korea are:

                                             1 Year                             2 Year

US                                          4.0%                             4.25%

S. Korea                                 3.0%                              3.25%

a. If this project were instead undertaken by a similiar US based company with the same risk adjusted cost of capital what would be the net present value and rate of return generated by this project?--Answer is $89,357; 20%--show all work and formulas to support answer.

b. What is the expected forward exchange rate 1 year from now and 2 years from now. (Hint: Take the perspective of the Korean Company when identifyinh home and foreign currencies and direct quotes of exchange rates.)--Answer is $1,039.90 won per US dollar and 1029.95 won per US dollar--show all work to support answer

c. If Nam Sung undertakes the project what is the net present value and rate of return of the project for Nam Sung?  Answer is $78,150,661 won; 18.85%--show all work and formulas to support answer.                              

Explanation / Answer

a) Enter the cash flows in an excel sheet as follows

NPV of this project for a US based company can be calculated as follows

NPV =NPV(13%,B3:B4) - 1000000 = $89,357.04

IRR for this project can be calculated as follows

IRR =IRR(B2:B4) = 20.00%

Here cells B2 to B4 has cash flows from year 0 till year 2 respectively

b) Expected foreign exchange rate in year 1 = Current FX rate * (1+ S Korea RF 1) / (1+ US RF 1)

= 1050 * (1.03 / 1.04) = 1,039.40 per dollar

Expected foreign exchange rate in year 2 = Current FX rate * ((1+ S Korea RF 1) / (1+ US RF 1))2

= 1050 * (1.035 / 1.045)2 = 1,029.95 per dollar

c) Using the exchange rates in the respective years, calculate the cash flows in won currency as follows

NPV of this project can be calculated as follows

NPV =NPV(13%,D3:D4) - 1050000000 = $78,150,661.63

IRR for this project can be calculated as follows

IRR =IRR(D2:D4) = 18.85%

Here cells D2 to D4 has cash flows from year 0 till year 2 respectively

Year Cash flow 0       (1,000,000.00) 1             700,000.00 2             600,000.00

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