Question

An Australian company is considering making a foreign capital expenditure in New Zealand. The cost of the project is NZD 1m and it is expected to generate cash flows of NZD 350,000, NZD 300,000 and NZD 650,000 over three years.

The inflation rate in New Zealand is 3.2%pa and the inflation rate in Australia is 4.1%pa. The inflation rates are forecasted to be unchanged over the investment horizon.

The firm's cost of capital in Australian dollars is 12.5%. The current exchange rate is S(NZD/AUD)=1.10. Ignore any tax effects (i.e. assume the tax rate is zero).

Calculate a NZD equivalent cost of capital according to the Fisher Effect, calculate the NPV of the project in NZD and convert it to AUD at the current spot rate to get the NPV of the project in AUD. (Show all workings)

Answer 1

We have assumed that the given 12.5% rate is nominal rate, if we assume it to be real the Kc (NZD) will be different.