You are evaluating a proposed expansion of an existing subsidiary located in Swi

Question

You are evaluating a proposed expansion of an existing subsidiary located in Switzerland. The cost of the expansion would be SF 18 million. The cash flows from the project would be SF 5.5 million per year for the next five years. The dollar required return is 15 percent per year, and the current exchange rate is SF 1.05. The going rate on Eurodollars is 4 percent per year. It is 3 percent per year on Euroswiss. Use the approximate form of interest rate parity in calculating the expected spot rates.

Convert the projected franc flows into dollar flows and calculate the NPV

What is the required return on franc flows

What is the NPV of the project in Swiss francs

What is the NPV in dollars if you convert the franc NPV to dollars

What is the NPV of the project in Swiss francs

What is the NPV in dollars if you convert the franc NPV to dollars

Explanation / Answer

1.) Dollar Returns = 1.15

Using Relative Purchasing Power Parity concept, Swiss Return

E(t) = 1.15x(1+(0.03-0.04)) -1 = 1.1385 - 1 = 0.1385 or 13.85%

NPV in Swiss Francs = -18,000,000 + 5,500,000x{(1-1.1385-5)/0.1385} = -18,000,000 + 18,950,216 = SF 950,216

NPV in Dollar Terms =950,216/1.05 =$904,468

b.) Spot Rate,S = 1.05

E(t) = 1.05x(1+(0.03-0.04))t = 1.05*0.99t

Cash flows from the project in USD terms will be,

=> -18,000,000/1.05; 5,500,500/(1.05*0.99); 5,500,500/(1.05*0.992); 5,500,500/(1.05*0.993); 5,500,500/(1.05*0.994); 5,500,500/(1.05*0.995);

=> -17,142,857; 5,291,005; 5,344,450; 5,398,434; 5,452,964; 5,508,044;

NPV in Dollar Terms = -17,142,857 + 5,291,005/1.15 + 5,344,450/1.152 + 5,398,434/1.153 + 5,452,964/1.154 + 5,508,044/1.155

=-17,142,857 + 4,600,874 + 4,041,172 + 3,549,558 + 3,117,750 + 2,738,471

= $904,968

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