Question

Lakonishok Equipment has an investment opportunity in Europe. The project costs €12 million and is expected to produce cash flows of €2 million in Year 1, €2.4 million in Year 2, and €3.5 million in Year 3. The current spot exchange rate is $1.35/€; and the current risk-free rate in the United States is 2.0 percent, compared to that in Europe of 2.8 percent. The appropriate discount rate for the project is estimated to be 14 percent, the U.S. cost of capital for the company. In addition, the subsidiary can be sold at the end of three years for an estimated €9 million. Use the exact form of interest rate parity in calculating the expected spot rates. What is the NPV of the project in U.S. dollars?

Answer 1

Lakonishok	0	1	2	3
$/€	1.35	1.34	1.33	1.32
CF (€)	-12	2	2.4	12.5
CF ($)	$ (16.20)	$      2.68	$      3.19	$   16.48
NPV ($)	($0.27)

Forward Rate ($/€) = Spot Rate ($/€) x (1 + $ rate) / (1 + € rate) = 1.35 x (1 + 2%) / (1 + 2.8%) = 1.34 and so on.

Cash Flows in dollars (CF $) = CF (€) x Exchange rate ($/€)

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

= -16.20 + 2.68 / 1.14 + 3.19 / 1.14^2 + 12.5 / 1.14^3

= -$0.27 million