Question

[The following information applies to the questions displayed below.]

The actual relationship between a nominal rate, R, a real rate, r, and an inflation rate, h, can be written as:

1 + r = (1 + R)/(1 + h)

This is the domestic Fisher effect.

(d)

Your company has a project in France. The project's cost is €2 million and the cash flows are €.9 million per year for the next three years. The dollar required return is 10% and the current exchange rate is €0.500. The risk-free rate on euros is 7% per year. It is 5% per year on the dollar. The NPV for the project using the exact forms for UIP and the international Fisher effect is $. (Do not include the dollar sign ($). Input your answer in dollars, not in millions, e.g, $1,234,567.89. Round your answer to 2 decimal places. (e.g., 32.16))

Answer 1

	0	1	2	3
€/$	0.500	0.510	0.519	0.529
Cashflow (€)	-€   2,000,000	€    900,000	€    900,000	€    900,000
Cashflow ($)	-$   4,000,000	$ 1,766,355	$ 1,733,339	$ 1,700,940
NPV	$316,230.72

First, we need to forecast exchange rates for the next three years.

Future rate (€/$) = Current rate (€/$) x (1 + rate (€)) / (1 + rate ($))

For year 1, rate = 0.500 x (1 + 7%) / (1 + 5%) = 0.510 and so on...

Now, convert the dollar cash flows in euro cash flows with the corresponding exchange rate.

Cash Flow ($) = Cash Flow (€) / rate (€/$)

NPV ($) = - CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + CF3 / (1 + r)^3

= - 4,000,000 + 1,766,355 / (1 + 10%) + 1,733,339 / (1 + 10%)^2 + 1,700,940 / (1 + 10%)^3

= $316,230.72