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27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand but
is considering establishing a subsidiary there. The following information has been gathered to assess
this project:
The initial investment required is $50 million in New Zealand dollars (NZ$). Given the existing
spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In
addition to the NZ$50 million initial investment for plant and equipment, NZ$20 million is
needed for working capital and will be borrowed by the subsidiary from a New Zealand bank.
The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 14
percent. The loan principal is to be paid in 10 years.
The project will be terminated at the end of Year 3, when the subsidiary will be sold.
The price, demand, and variable cost of the product in New Zealand are as follows:
Year Price Demand Variable Cost
1 NZ$500 40,000 units NZ$30
2 NZ$511 50,000 units NZ$35
3 NZ$530 60,000 units NZ$40
The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at
the end of Year 2, and $.56 at the end of Year 3.
The New Zealand government will impose an income tax of 30 percent on income. In addition, it
will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The U.S.
government will allow a tax credit on the remitted earnings and will not impose any additional
taxes.
All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The
subsidiary will use its working capital to support ongoing operations.
The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ$50 million, the annual
depreciation expense is NZ$5 million.
In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the
existing New Zealand loan. The working capital will not be liquidated but will be used by the
acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52 million after
subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
Wolverine requires a 20 percent rate of return on this project.
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1) × (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the parent
would invest an additional $10 million to cover the working capital requirements so that the
subsidiary would not need the New Zealand loan. If this arrangement is used, the selling price of the
subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this
alternative financing arrangement more feasible for the parent than the original proposal? Explain.
ANSWER: This alternative financing arrangement will have the following effects. First, it will
Capital Budgeting Analysis with an Alternative
Financing Arrangement: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1)×(2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent
invests more of its own funds to cover the working capital? Explain.
ANSWER: The NPV would be more sensitive to exchange rate movements if the parent uses its own
financing to cover the working capital requirements. If it used New Zealand financing, a portion of
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the
end of Year 3. How is the project’s NPV affected?
ANSWER: The effects of the blocked funds are shown below:
Year 1 Year 2 Year 3
13. Net cash flow to subsidiary
=(12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$ 15,920,000
NZ$ 12,720,000
NZ$ 9,550,600
e. What is the break-even salvage value of this project if Wolverine uses the original financing proposal
and funds are not blocked?
First, determine the present value of cash flows when excluding salvage value:
End of Present Value of Cash Flows
Year (excluding salvage value)
1 $ 3,315,000
f. Assume that Wolverine decides to implement the project, using the original financing proposal.
Also assume that after one year, a New Zealand firm offers Wolverine a price of $27 million after
taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not
changed. Compare the present value of the expected cash flows it Wolverine keeps the subsidiary
to the selling price. Should Wolverine divest the subsidiary? Explain.
ANSWER:
Divestiture Analysis One Year After
the Project Began
End of Year 2 End of Year 3
(one year from now) (two years from now)
Cash flows to parent $5,832,000 $37,143,680
PV of parent cash
flows forgone if
28. Capital Budgeting With Hedging. Baxter Co. considers a project with Thailand’s government. If it
accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht in five
years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a 5-year
period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to hedge its
cash flows with a forward contract. What is the dollar amount of cash flows that Baxter will receive
in five years if it accepts this project?
ANSWER: The forward rate premium is:
29. Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the
French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the unit.
It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes
are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years.
Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free
interest rate is 5% regardless of the maturity of the debt, and the annualized risk-free interest rate on
euros is 7%, regardless of the maturity of debt. Assume that interest rate parity exists. Cantoon’s cost
of capital is 20%. It plans to use cash to make the acquisition.
a. Determine the NPV under these conditions.
b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan of
3 million euros today that would be used to cover a portion of the acquisition. In this case, it
would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the
loan. There are no interest payments on this debt. This financing deal is structured such that none
of the payment is tax-deductible. Determine the NPV if Cantoon uses the forward rate instead of
the spot rate to forecast the future spot rate of the euro, and elects to partially finance the
acquisition. [You need to derive the 8-year forward rate for this question.]
ANSWER
a. Discount factor based on a required return of 20% for 8 years = .232
30. Sensitivity of NPV to Conditions. Burton Co., based in the U.S., considers a project in which it
has an initial outlay of $3 million and expects to receive 10 million Swiss francs (SF) in one year. The
spot rate of the franc is $.80. Burton Co. decides to purchase put options on Swiss francs with an
exercise price of $.78 and a premium of $.02 per unit to hedge its receivables. It has a required rate of
return of 20 percent.
a. Determine the net present value of this project for Burton Co. based on the forecast that the Swiss
franc will be valued at $.70 at the end of one year.
b. Assume the same information in part (a), but with the following adjustment. While Burton
expected to receive 10 million Swiss francs, assume that there were unexpected weak economic
conditions in Switzerland after Burton initiated the project. Consequently, Burton received only 6
million Swiss francs at the end of the year. Also assume that the spot rate of the franc at the end of the
year was $.79. Determine the net present value of this project for Burton Co. if these conditions occur.
ANSWER
a. [SF10,000,000 x ($.78)]/1.2=$6,500,000 – premium of $200,000 (computed as $.02 x 10 million)
b. [6,000,000 x $.79]/1.2 = $3,950,000
31. Hedge Decision on a Project. Carlotto Co. (a U.S. firm) will definitely receive 1 million British
pounds in one year based on a business contract it has with the British government. Like most firms,
Carlotto Co. is risk averse and only takes risk when the potential benefits outweigh the risk. It has no
other international business, and is considering various methods to hedge its exchange rate risk.
Assume that interest rate parity exists. Carlotto Co. recognizes that exchange rates are very difficult to
forecast with accuracy, but it believes that the one-year forward rate of the pound yields the best
forecast of the pound’s spot rate in one year. Today the pound’s spot rate is $2.00, while the one-year
forward rate of the pound is $1.90. Carlotto Co. has determined that a forward hedge is better than
alternative forms of hedging. Should Carlotto Co. hedge with a forward contract or should it remain
unhedged? Briefly explain.
ANSWER: The project is more feasible if it hedges, because the expected dollar cash flows are the
32. NPV of Partially Hedged Project. Sazer Co. (a U.S. firm) is considering a project in which it
produces special safety equipment. It will incur an initial outlay of $1 million for the research and
development of this equipment. It expects to receive 600,000 euros in one year from selling the
products in Portugal where it already does much business. In addition, it also expects to receive
300,000 euros in one year from sales to Spain, but these cash flows are very uncertain because it has
no existing business in Spain. Today’s spot rate of the euro is $1.50 and the one-year forward rate is
$1.50. It expects that the euro’s spot rate will be $1.60 in one year. It will pursue the project only if it
can satisfy its required rate of return of 24 percent. It decides to hedge all the expected receivables
due to business in Portugal, and none of the expected receivables due to business in Spain. Estimate
the net present value (NPV) of the project.
ANSWER:
Cash flows from Portugal business (hedged): 600,000 euros × $1.50 = $900,000.
33. Project Financing Strategy. Konk Co., a U.S. firm, considers a project in which it would build a
subsidiary in Belgium that would generate net cash flows of about 10 million euros per year for 5
years and would remit that amount to the parent each year. It has no other international business. It
needs about 20 million euros as the initial outlay to establish the subsidiary. It can finance this initial
outlay in the following ways and the subsidiary would repay the amount of the investment evenly
over the next 5 years: (a) the parent can borrow dollars from a U.S. bank and convert them to euros,
(b) the parent can borrow euros from a Belgian bank, (c) the parent can use its equity (retained
earnings from existing business in the U.S.) and convert the funds into euros, (d) the parent can
borrow dollars from a Belgian bank and convert them to euros, and (e) the parent can diversify its
financing by obtaining one-fourth of the funds from each of the preceding sources. Assume that there
is no cost advantage to any financing method. If Konk Co. wants to use a financing method to
minimize its project’s exposure to exchange rate risk, which method should it use? Briefly explain.
ANSWER: It should borrow euros, so that a portion of its euro earnings are used to pay off a loan
34. NPV and Financing. Louisville Co. is a U.S. firm considering a project in Austria which it has an
initial cash outlay of $7 million. Louisville will accept the project only if it can satisfy its required
rate of return of 18 percent. The project would definitely generate 2 million euros in one year from
sales to a large corporate customer in Austria. In addition, it also expects to receive 4 million euros in
one year from sales to other customers in Austria. Louisville's best guess is that the euro’s spot rate
will be $1.26 in one year. Today, the spot rate of the euro is $1.40, while the one-year forward rate of
the euro is $1.34. If Louisville accepts the project, it would hedge all the receivables resulting from
sales to the large corporate customer, and none of the expected receivables due to expected sales to
other customers.
a. Estimate the net present value (NPV) of the project.
b. Assume that Louisville considers alternative financing for the project, in which it would use $5
million cash, and the remaining initial outlay would come from borrowing euros. In this case, it
would need 1,600,000 euros to repay the loan (principal plus interest) at the end of one year. Assume
no tax effects due to this alternative financing. Estimate the NPV of the project under these
conditions.
c. Do you think the Louisville's exposure to exchange rate risk due to the project if it uses the
alternative financing (explained in part b) is higher, lower, or the same as if it has an initial cash
outlay of $7 million (and does not borrow any funds)? Briefly explain.
ANSWER:
a.
Cash flows (hedged): 2,000,000 euros × $1.34 = $2,680,000.
b. Revise the previous answer in part (a) by reducing the CF in euros by 1,600,000 and reducing the
initial outlay from $7 million to $5 million.
c. Partial financing with euros reduces exposure to exchange rate risk, because a portion of the funds
will be converted to pay off euro loan before funds are remitted to the U.S.
