Question

In a bid to gain greater acceptance in Asian markets, Wide Bay Cookies Ltd is evaluating an opportunity to produce and distribute its products from a new manufacturing plant in Vietnam. Wide Bay will invest AUD $3,000,000 to set up the factory and provide working capital for operations. AUD $2,000,000 of this initial outlay will be recovered when the project is terminated in four years’ time. Wide Bay expect to receive 13,000,000,000 Vietnamese Dong (VND) after tax for each of the four years of operation. The current spot rate is AUD VND 15 746.72.

The risk free rate in Australia is 1% while it is 4.45% in Vietnam. You should assume that interest rate parity exists. Wide Bay Cookies works on the assumptions that the one year forward rate predicts the spot rate in one years’ time and that the change in the exchange rate in the first year will be repeated for each year of the project. Wide Bay’s annual required return for the project is 12%.

Rice Paper Ltd is an Australian company that imports Vietnamese products. Rice Paper’s contracts are written in Vietnamese Dong and they agree to take 13,000,000,000 each year from Wide Bay Cookies at the rate of AUD VND 14 000.

a) Ignoring any tax implications, what is the net present value of the project for Wide Bay Cookies if it does not hedge the project’s cash flows?

b) Ignoring any tax implications, what is the net present value of the project for Wide Bay Cookies if it engages in the currency swap?

c) Should Wide Bay undertake the project? Justify your answer.

Answer 1

a) net present value of the project for Wide Bay Cookies if it does not hedge the project’s cash flows is AUD (1,410,814)

	Years	0	1	2	3	4
A	Factory	-30,00,000
B	WC	-20,00,000				20,00,000
C	Operations CFs - VND		13,00,00,00,000	13,00,00,00,000	13,00,00,00,000	13,00,00,00,000
D = C/Forward Rates	Operations CFs - AUD		7,98,300	7,71,932	7,46,435	7,21,780
E= A+B+D	Total CFs	-50,00,000	7,98,300	7,71,932	7,46,435	27,21,780
F	Df	1.00	0.89	0.80	0.71	0.64
G=E*F	PV	-50,00,000	7,12,768	6,15,380	5,31,298	17,29,741
H=Sum of G	NPV	-14,10,814

IRP states:

F=S*(1+Rf -VND)/(1+Rf -AUD)

VND /AUD	15746.72
Rf - AUD	1%
Rf - VND	4.45%
Term	Forward Rates
0	15,746.72
1	16,284.60
2	16,840.86
3	17,416.12
4	18,011.02

b) net present value of the project for Wide Bay Cookies if it engages in the currency swap is AUD (908,568)

	Years	0	1	2	3	4
A	Factory	-30,00,000
B	WC	-20,00,000				20,00,000
C	Operations CFs - VND		13,00,00,00,000	13,00,00,00,000	13,00,00,00,000	13,00,00,00,000
D = C/14000	Operations CFs - AUD		9,28,571	9,28,571	9,28,571	9,28,571
E= A+B+D	Total CFs	-50,00,000	9,28,571	9,28,571	9,28,571	29,28,571
F	Df	1.00	0.89	0.80	0.71	0.64
G=E*F	PV	-50,00,000	8,29,082	7,40,251	6,60,939	18,61,160
H=Sum of G	NPV	-9,08,568

c)  Wide Bay should not undertake the project as the NPV based on both hedged and unhedged cash flows is negative.