Etemadi? Amalgamated, a U.S. manufacturing? firm, is considering a new project in Portugal. You are in?Etemadi's corporate finance department and are responsible for deciding whether to undertake the project. The expected free cash? flows, in? euros, are shown? here:
|
Year |
0 |
1 |
2 |
3 |
4 |
| Free Cash Flow
?(euro€ ?million) |
?15.1 |
9.5 |
10.4 |
10.8 |
12.1 |
You know that the spot exchange rate is $0.86/€. In? addition, the? risk-free interest rate on dollars is 4.1% and the? risk-free interest rate on euros is 5.7%. Assume that these markets are internationally integrated and the uncertainty in the free cash flows is not correlated with uncertainty in the exchange rate. You determine that the dollar WACC for these cash flows is 8.1%. What is the dollar present value of the? project? Should Etemadi Amalgamated undertake the? project? (Enter all outflows of cash as negative? numbers.)
| Year | FCF (€) | Exchange | FCF ($) |
| 0 | -15.1 | $ 0.860 | -$ 12.99 |
| 1 | 9.5 | $ 0.847 | $ 8.05 |
| 2 | 10.4 | $ 0.834 | $ 8.68 |
| 3 | 10.8 | $ 0.822 | $ 8.87 |
| 4 | 12.1 | $ 0.809 | $ 9.79 |
| NPV | $16.075 |
Forecast the exchange rates using interest rate parity,
Forward Rate = Spot Rate x (1 + USD rate) / (1 + EUR rate)
In year 1, Exchange rate = 0.86 x (1 + 4.1%) / (1 + 5.7%) = 0.847 and so on for other years.
Convert the euro cash flows in dollar cash flows using the forecasted exchange rates.
NPV = -CF0 + CF1 / (1 + r) +... + CF4 / (1 + r)^4
= -12.99 + 8.05 / 1.081 + 8.68 / 1.082^2 + 8.87 / 1.082^3 + 9.79 / 1.082^4
= $16.075 million
As the NPV > 0, the firm should undertake the project.
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