Question

3. Schnell, Inc., has been approached by the government of Malaysia to engage in a project there over the next year. Schnell’s investment in the project is 2 million Malaysian ringgit (MR), and the project is expected to generate cash flows of MR2.7 million next year. The project will terminate at that time. The current value of the ringgit is $.27, but Schnell believes that the ringgit will depreciate substantially over the next year. Specifically, it believes the ringgit will have a value of $.21 next year. Furthermore, Schnell will have to borrow for 1 year in order to pursue the project and will incur financing costs of 12 percent over the next year. Assume that Schnell and the Malaysian government could engage in a parallel loan, in which the Malaysian government will give Schnell MR2 million in exchange for a loan in dollars at the current exchange rate. These loans will be repaid by both parties at the end of 1 year when the project is completed.

Assume that next year, Schnell will pay the Malaysian government 16 percent interest on the MR1 million, and the Malaysian government will pay Schnell 8 percent interest on the dollar loan. Calculate dollar and foreign currency cash inflows and outflows if the company engages in parallel loan. Is the arrangement feasible if Schnell’s discount rate is 10%?

Answer 1

Initial Investment: MR 2 Million

Cash Flow at the end of the Year = MR 2.6 Million

MR/USD = $ 0.27

Expected value of MR/USD in one Year = $ 0.21

Interest cost of Schnell = 12%

Schnells Discount rate (r) = 10%

Parallel Loan to be taken by Malaysian Government = MR 1 Million @ 16 %

Parallel Loan to be given to Malaysian Government = MR 1 Million x 0.27 = $ 270000 @ 8%

Currency Flow if parallel loan MR 1 Million is done:

Schnell	Malaysian Government
Loan Given to Malaysian Government	Loan received from Schnell in $ converted to MR
CF0 = -$270000	CF0 = $ 270000 @ $0.27 = MR 1000000
CF1= $291000 ($270000 @ 8%)	CF1 = - $ 291600 @ $ 0.21 @ 8% = - MR 1388571.4
Loan Received from Malaysian Government (In MR converted to $)	Loan given to Schnell
CF0 = MR 1000000 @ $0.27 = $ 270000	CF0 = - MR 1000000
CF1 = - MR 1160000 @ $ 0.21 = - $243600	CF1 = MR1160000 (MR 1000000 @ 16%)
Nett Currency Flow to Schnell	Nett Currency Flow to Malaysian Government
CF0 = - $270000 + $ 270000 = 0	CF0 = MR1000000 – MR1000000
CF1 = $ 291000 - $ 243600 = $ 47400	CF1 = -MR1388571.4 + MR 1160000 = -MR228571.4

Project Feasibility for Schnell if loan is taken and discount rate is 10%

Equity = MR 1000000 @ 12%

Loan from Malaysian Government = MR 1000000 @ 16%

WACC = +

                = +

                 = 14%

Interest Cost = 2000000 x 14% = MR280000

Interest Income from Parallel Loan = $ 270000 @ 8% = $21600 @ $0.21 = MR 102857.1

Project NPV

CF0 = MR 2000000

CF1 = Cash generated + interest cost + interest income = 2600000 – 280000 + 102857.1 = MR2422857.1

NPV = -2000000 +

NPV = -2000000 + 2202597.4

NPV = MR202597.4

Hence the project is feasible for Schnell