Reference no: EM132782387

Texas Engineering is an American company that is considering to establish a subsidiary in Australia that would cost US$ 20 million. The Australian project would terminate after three years. The expected spot rates for the Australian dollar at the end of the first, second, and third years are US$ 0.70, US$ 0.68 and US$ 0.67, respectively. As for the relevant forward rate, one A$ is worth US$ 0.70, US$ 0.69, and US$ 0.68 at the end of the first, second, and third year, respectively. The Australian project is forecasted to remit net cash flows (after withholding tax) of A$10,000,000, A$11,000,000, and A$14,800,000 at the end of the first, second, and third year, respectively. Texas Engineering finances its operation with 40% equity and the remainder is financed with dollar-denominated debt, which attracts an interest rate of 11% per annum.

• The risk-free rate in Australia is 4%, while the similar risk-free rate in the U.S. is 6% per annum. The stock market return in the U.S. is expected to be 13% annually, while the Australian stock market return is expected to be 12.5% annually. The shares of Texas Engineering are riskier than the U.S. stock market with an expected beta of 1.25. The relevant tax rate for Texas Engineering in the U.S. is 30%, while the Australian subsidiary is taxed at 25% in Australia.

Problem a. Calculate the net present value (NPV) of the project assuming that Texas Engineering can convert the A$ income at the expected spot rate. What is your recommendation?

Problem b. Suppose, Texas Engineering wishes to fully hedge the remitted cash flows using forward contract. Calculate the project NPV. What is your recommendation?