Question 1: Net present value if invested by a US company
If a US company undertakes the project, exchange rates and differences in interest rates will not affect the determination of the net present value (Shapiro, 2010). At 12% cost of capital, the discounting rate in 1 year will be 0.8996. In application of the discount rate, the net present value will be $79.52.
Cash flow in US $ | $ 1,200.00 |
Discounting rate at 12% | 0.8996 |
Present value | $ 1,079.52 |
Present value of the initial cash outflow | $ 1,000.00 |
NPV | $ 79.52 |
The rate of return from the project is determined by dividing the discounted returns (NPV) by the initial investment times 100%. The rate of return is 8%.
Rate of return | 8% |
NPV in US ($) |
79.52 |
Initial investment ($) |
1,000.00 |
Question 2: Expected forward exchange rate
The expected forward exchange rate is determined amid the realization that the exchange rate can keep on changing from time to time (Shapiro, 2010). Interest rates in different countries play a role in determining the rate on exchange rates and hence are involved prominently in the calculation. The exchange rate is calculated by the formula Sport rate (1+ r_{h}) / (1+r_{f}). Where, Sport rate is in this case 0.9, r_{h, }is the interest rates in the home country (Swiss) and r_{f }the interest rate in the foreign county(USA).
Expected forward exchange rate | |
Sport rate | 0.9 |
r-h | 0.035 |
r-f | 0.05 |
1+ r-h | 1.035 |
1+r-f | 1.05 |
(1+ r_{h}) / (1+r_{f}) | 0.985714286 |
Expected forward exchange rate | 0.89 |
The Net Present Value: If Solitaire Undertakes the Project
If Solitaire undertakes the project in USA, it implies that the exchange rates and the different interest rates will play a role in the determination of the net present value of the project. Since the company is based in Swiss, it implies that it will report in the Swiss Franc, hence the need to convert the US$ into the Franc. The sport rate $ 1 = Fr. 0.9, and hence conversion will involve the multiplication of the $s by 0.9 during years 0. The expected forward exchange rate of 0.89 will be applied at the end of the first year to find the value of the cash in flow. The value of cash flow after 1 year will be subjected to a discount rate at 12% to incorporate the concept of the future value of money to get the present value. The present value minus the initial outflow gives the NPV. The net present value is in this case fr. 57.69 or $ 65.03.
Year 0 | Year 1 | |
Cash flow in US $ | $ (1,000.00) | $ 1,200.00 |
Expected exchange rates | 0.9 | 0.89 |
Cash flow in Swiss franc. | fr. -900.00 | fr. 1,064.57 |
Discounting rate at 12% | 1 | 0.8996 |
Present value | fr. -900.00 | fr. 957.69 |
NPV: | ||
Present-value of cash inflow | fr. 957.69 | |
Present value of the initial cash outflow | fr. -900.00 | |
NPV in Swiss Franc. | fr. 57.69 | |
Expected exchange rates | 0.89 | |
NPV in US $ | $ 65.03 |
The rate of return for the project is 7%. The rate in this case is less than when US based company invests in the same project. It implies that exchange rate and differences in interest rates affects the rate of return.
Rate of return | |
NPV in US $ | $ 65.03 |
Initial investment | $ 1,000.00 |
7% |
Reference
Shapiro, A. C. (2010). Multinational financial management. New York: Wiley.