Question

Assume a potential target in Japan generates cash flows of EUR 1,000 in year 1 and EUR 2,000 in year 2. Also assume that the predicted exchange rate for the next two years is a constant USD 1.00 per EUR and an MNC requires 10% rate of return. Assume no taxes. Show your work for full credit. (4 points)

a) What is the maximum the MNC would pay for the potential target? Note: 100/1.1 = 90.91 and 100/1.1^2 = 82.64

b) If the potential target is a public company with 1,000 shares outstanding, each trading for EUR 2, should the MNC purchase the target? Assume the current exchange rate is USD 1.20 per EUR and the shareholders require no premium.

Please show your work not using Excel. Thanks!

Answer 1

(a) Exchange Rate = $ 1 per EUR (remains constant during the evaluation period)

Required Rate of Return = 10%

Cash Flows: 1000 EUR at the end of year 1 and EUR 2000 at the end of year 2.

Intrinsic Firm Value = 1000 / 1.1 + 2000 / (1.1)^(2) = 2561,9 EUR or $ (as exchange rate is $ 1 per EUR and constant)

Maximum Value Payabel is equal to the firm's Intrinsic Value which is equal to $ 2561.9

(b) Intrinsic Firm Value at Present (t=0) = 2561.9 EUR

Current Exchange Rate = $ 1.2 per EUR

Intrinsic Value in $ = 2561.9 x 1.2 = $ 3074.28

Shares Outstanding = 1000

Intrinsic Value per Share = 3074.28 / 1000 = $ 3.07428

Market Value per Share = 2 EUR or $ 2.4 per share

As Intrinsic Value per Share > Market Value per Share, the target is clearly undervalued, which implies that the MNC is getting the opportunity to purchase this firm at a discount. Hence, it is a recommeneded purchase.