Question

Lakonishok Equipment has an investment opportunity in Europe. The project costs €15 million and is expected to produce cash flows of €1.7 million in year 1, €3.4 million in year 2, and €2.7 million in year 3. The current spot exchange rate is $1.15/€; the current risk-free rate in the United States is 4.9 percent, compared to that in Europe of 4.8 percent. The appropriate discount rate for the project is estimated to be 17 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 €8.2 million. What is the NPV of the project?

Answer 1

Answer :

To calculate the NPV, first we need to compute the interest rate parity forward rates:

Year	Formula	Calculation	Forward rate
1	Spot rate * ( 1 + Hi ) / ( 1 + Fi )	1.15 * ( 1.049 ) / ( 1.048 )	1.1511
2	Spot rate * ( 1 + Hi )^2 / ( 1 + Fi )^2	1.15 * ( 1.049 )^2 / ( 1.048 )^2	1.1522
3	Spot rate * ( 1 + Hi )^3 / ( 1 + Fi )^3	1.15 * ( 1.049 )^3 / ( 1.048 )^3	1.1533

NPV = PV of cash inflows - PV of cash outflows

Year	Cash flow in Euro	Exchange rate	Cash flow in USD	PVF @17%	Discounting CF
0	€ (15,000,000 )	1.1500	$ ( 17,250,000 )	1.0000	$ ( 17,250,000 )
1	€ 1,700,000	1.1511	$ 1,956,870	0.8547	$ 1,672,536.79
2	€ 3,400,000	1.1522	$ 3,917,480	0.7305	$ 2,861,719.14
3	€ 2,700,000	1.1533	$ 3,113,910	0.6244	$ 1,944,325.40
3	€ 8,200,000	1.1533	$ 9,457,060	0.6244	$ 5,904,988.26
				NPV =>	- $ 4,866,430.41

NPV of the project is - $ 4,866,430.41