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Msdi Alcala de Henares, Spain: Click To Edit Master Subtitle Style

The document discusses two methods (Method A and Method B) for calculating the net present value (NPV) of a project with cash flows denominated in a foreign currency. Method A discounts future foreign currency cash flows using the foreign weighted average cost of capital (WACC) and converts to the reporting currency at spot rates, while Method B converts future cash flows to the reporting currency at expected spot rates and discounts using the domestic WACC. The document recommends Method B because it is clearer what assumptions are being made in the form of expected spot rates, compared to Method A which embeds assumptions in the foreign WACC. An example calculation is provided of a machinery replacement project for a Spanish subsidiary, comparing NPVs under different approaches

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Shashank Shekhar
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240 views

Msdi Alcala de Henares, Spain: Click To Edit Master Subtitle Style

The document discusses two methods (Method A and Method B) for calculating the net present value (NPV) of a project with cash flows denominated in a foreign currency. Method A discounts future foreign currency cash flows using the foreign weighted average cost of capital (WACC) and converts to the reporting currency at spot rates, while Method B converts future cash flows to the reporting currency at expected spot rates and discounts using the domestic WACC. The document recommends Method B because it is clearer what assumptions are being made in the form of expected spot rates, compared to Method A which embeds assumptions in the foreign WACC. An example calculation is provided of a machinery replacement project for a Spanish subsidiary, comparing NPVs under different approaches

Uploaded by

Shashank Shekhar
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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MSDI

Alcala de Henares, Spain


Click to edit Master subtitle style

Now

Future

U.S. Dollar
NPV

Cash
Flows
Spanish Peseta

Cash Flows

Forecast foreign currency free cash flows

Incorporate expected foreign currency inflation

Use appropriate effective tax rate: generally the


higher of the foreign or domestic tax rates

Include the terminal value: the market value of


disposal or the value of the perpetual cash flows

Discount

Method A: Discount at foreign WACC and


convert at spot rate

Method B: Convert at expected spot rates


and discount at domestic WACC

Method A
Now

Future

U.S. Dollar
NPV

Cash
Flows
Spanish Peseta

Method B
Now

Future

U.S. Dollar
NPV

Cash
Flows
Spanish Peseta

Recommend Method B

Companies should know their domestic WACC


but may not know the foreign WACC

Methods for forecasting spot rates are the same as


converting a domestic WACC to a foreign WACC
(forward parity, international Fisher effect,
purchasing power parity)

Method B makes it much clearer what your


assumptions are (in the form of expected spot
rates) than Method A (in the form of a foreign

Cash Flows

Installed cost of new machinery


Disposal of old machinery: net of market
value and tax effect of disposal
After tax operating cost savings
Tax effects of loss of old machinery
depreciation and gain of new machinery
depreciation
No terminal cash flows

Installed Cost of New Machinery

61,525,000 ESP

Disposal of Old Machinery

950,000 ESP Market Value


1,605,000 ESP Book Value
655,000 ESP (1,605,000-950,000) Loss on
Sale
229,250 ESP (655,000 x .35) Tax Benefit of
Sale
1,179,250 ESP (950,000+229,250) Net
Effect of Sale of Old Machinery

After Tax Operating Cost


Savings
Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997

Old Cost
88,496
88,662
93,686
97,634
101,091
104,872
109,101
113,765
119,012
124,872

New Cost
69,676
69,808
73,763
76,872
79,594
82,571
85,901
89,573
93,704
98,318

Cost Saving
18,820
18,854
19,923
20,762
21,497
22,301
23,200
24,192
25,308
26,554

After Tax
12,233
12,255
12,950
13,495
13,973
14,496
15,080
15,725
16,450
17,260

Loss of Old Machinery


Depreciation

1,605,000 ESP Book Value


3 Years Remaining Straight Line
Depreciation
535,000 ESP (1,605,000/3) Depreciation
per Year
187,250 ESP (535,000 x .35) Depreciation
Tax Savings per Year

Gain of New Machinery


Depreciation

61,525,000 ESP Book Value


10 Years Remaining Straight Line
Depreciation
6,152,500 ESP (61,525,000/10)
Depreciation per Year
2,153,375 ESP 6,152,500 x .35)
Depreciation Tax Savings per Year

Net Cash Flows


Year

0
1 (1988)
2 (1989)
3 (1990)
4 (1991)
5 (1992)
6 (1993)
7 (1994)
8 (1995)
9 (1996)
10 (1997)

Installed Cost
of New Machinery
(61,525,000)

Disposal
of Old Machinery

Net Operating
Cost Savings

Old Machine
Depreciation

New Machine
Depreciation

1,179,250
12,233,000
12,255,100
12,949,950
13,495,300
13,973,050
14,495,650
15,080,000
15,724,800
16,450,200
17,260,100

(187,250)
(187,250)
(187,250)

2,153,375
2,153,375
2,153,375
2,153,375
2,153,375
2,153,375
2,153,375
2,153,375
2,153,375
2,153,375

Net
Cash Flows
(60,345,750)
14,199,125
14,221,225
14,916,075
15,648,675
16,126,425
16,649,025
17,233,375
17,878,175
18,603,575
19,413,475

Forward Rates
(Forward Parity)

Spot Rate: 127.00 ESP/USD

1-Month Forward Rate: 125.85 ESP/USD

3-Month Forward Rate: 123.70 ESP/USD

Expected Spot Rate Factor = .8961


((((123.70-127.00)/127.00) x 4) + 1)

Interest Rates
(International Fisher Effect)

Spanish Rates (Case): Short-Term Loans 18%;


Long-Term Loans 15%
Spanish Rates (Exhibit 3): Daily Interbank Rate
18.1%; 6-12 Month Deposit Rate 8.8%; ShortTerm Commercial Loans 17.9%
U.S. Rates (Case): Prime Loan Rate 8.5%
U.S. Rates (Exhibit 4): 3 Month T-Bills 5.73%; 10
Year T-Bonds 8.34%; 6 Month Commercial Paper
6.85; Prime Commercial Rate 8.5%
Expected Spot Rate Factor = 1.0599 (1.15/1.085)

Inflation Rates
(Purchasing Power Parity)

Spanish CPI: 8.8%


U.S. CPI: 1.9%
Expected Spanish Inflation: 8%?
Expected U.S. Inflation: 4%?
Expected Spot Rate Factor (Historical
Inflation) = 1.0677 (1.088/1.019)
Expected Spot Rate Factor (Expected
Inflation) = 1.0385 (1.08/1.04)

Other Information

Economists 5-Year Forecasts: 80-170


ESP/USD

Spanish Real GDP Growth: 3.3%

U.S. Real GDP Growth: 2.9%

Expected Spot Rates


Year

Forward Rates

Interest Rates

Historical
Inflation Rates

Expected
Inflation Rates

Factor

0.8961

1.0599

1.0677

1.0385

0
1 (1988)
2 (1989)
3 (1990)
4 (1991)
5 (1992)
6 (1993)
7 (1994)
8 (1995)
9 (1996)
10 (1997)

127.00
113.80
101.98
91.38
81.89
73.38
65.76
58.92
52.80
47.32
42.40

127.00
134.61
142.67
151.22
160.27
169.87
180.05
190.83
202.27
214.38
227.22

127.00
135.60
144.78
154.58
165.04
176.22
188.15
200.89
214.49
229.01
244.51

127.00
131.89
136.97
142.24
147.72
153.40
159.31
165.44
171.81
178.43
185.30

Net
Cash Flows

(60,345,750)
14,199,125
14,221,225
14,916,075
15,648,675
16,126,425
16,649,025
17,233,375
17,878,175
18,603,575
19,413,475

USD Cash Flows


Year

0
1 (1988)
2 (1989)
3 (1990)
4 (1991)
5 (1992)
6 (1993)
7 (1994)
8 (1995)
9 (1996)
10 (1997)

Expected
Inflation Rates
127.00
131.89
136.97
142.24
147.72
153.40
159.31
165.44
171.81
178.43
185.30

Net
Cash Flows
(60,345,750)
14,199,125
14,221,225
14,916,075
15,648,675
16,126,425
16,649,025
17,233,375
17,878,175
18,603,575
19,413,475

USD
Cash Flows
(475,163.39)
107,659.25
103,829.39
104,865.19
105,937.04
105,124.00
104,507.17
104,164.83
104,056.08
104,263.95
104,769.42

NPV = 95,317.59 USD


Click to edit Master subtitle style

Method A: ESP Discount Rate

Forward Parity Discount Rate: 1.26% ((1.13 x .


8961)-1)

International Fisher Effect Discount Rate: 19.77%


((1.13 x 1.0599)-1)

Purchasing Power Parity Discount Rate (Historical


Inflation): 20.65% ((1.13 x 1.0677)-1)

Purchasing Power Parity Discount Rate (Expected


Inflation): 17.35% ((1.13 x 1.0385)-1)

Method A: ESP NPV


Year

0
1 (1988)
2 (1989)
3 (1990)
4 (1991)
5 (1992)
6 (1993)
7 (1994)
8 (1995)
9 (1996)
10 (1997)
Discount Rate

Net
Cash Flows
(60,345,750)
14,199,125
14,221,225
14,916,075
15,648,675
16,126,425
16,649,025
17,233,375
17,878,175
18,603,575
19,413,475
0.1735

NPV (ESP)

12,105,333.82

NPV (USD)

95,317.59

Comparative NPVs

Theory

Forward Rates

Interest Rates

Historical
Inflation Rates

Expected
Inflation Rates

NPV (ESP)

93,105,320.84

5,857,833.46

3,795,147.91

12,105,333.82

NPV (USD)

733,112.76

46,124.67

29,883.05

95,317.59

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