Question

Background:

Australian Dyes Pty Ltd manufactures high quality dyes for textiles and exports to Europe. The Indonesian government has invited Australian Dyes to open a manufacturing plant in Indonesia so imported dyes can be replaced by local production. If Australian Dyes makes the investment it will operate the plant for five years and then be required to sell the business as a going concern to Indonesian investors at the end of the fifth year. Australian Dyes believes a multiple of six times net earnings is a conservative estimate of the net (after tax) market value of the firm at that time. Australian Dyes will be allowed to repatriate 100% of all net income and depreciation funds to Australia at the end of each of the five years (ie: free cash flows).

Australian Dyes’ CFO believes that the firm should use a risk-adjusted discount rate in Indonesia that reflects Indonesia’s capital costs (16% is her estimate). She further believes that a risk-adjusted discount rate for the parent viewpoint capital budget is appropriate, on the assumption that international projects in a risky currency environment should require a higher expected return than other lower risk Australian projects which the firm evaluates using a 12% discount rate.

(Indonesian Corporate tax rate 22% / Australian Corporate tax rate 30% )

Other data gathered for the project analysis:

Initial Investment:

Building & equipment: AUD1,000,000

working capital AUD 300,000

Total investment AUD1,300,000

Expected sales:

Year 1: 20,000 dye sets, growing at 5% per year

Year 1 Sale Price: DR equivalent of AUD75 per dye set

Indonesian inflation is expected to average 5% per year, so sales price increases of 5% per year are thought reasonable.

Depreciation and working Capital recovery:

As an incentive the Indonesian government has allowed the building and equipment to be fully depreciated over 5 years on a straight line basis. However, the working capital will not be recouped as it will be part of the sale price.

Manufacturing costs:

Year 1 variable costs: IDR equivalent of AUD60 per dye set. Costs are expected to increase at 6%pa, marginally above the expected inflation rate.

Q1: Use the current spot rate for the Indonesian rupiah relative to the AUD and purchasing power parity to estimate the future end of year spot rate for each of the next 5 years, assuming Indonesia’s inflation remains at 5%pa and Australia’s at 2%pa over the five years.

Answer 1

Current Spot Rate : 1AUD=IDR 10410.3962

By using purchasing power parity theory formula i.e. AUD(1+inflation rate of AUD)ⁿ=IDR10410.3962(1+inflation rate of IDR)ⁿ

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