Reference no: EM131508887

MSDI - Alcala de Henares, Spain Case

Part 1 -

1. Conduct an NPV analysis of this project by discounting in the foreign currency and converting to the domestic currency at today's spot exchange rate. Assume that Merck is using 8% as their estimate of peseta inflation and 4% as the estimate for inflation in the U.S. for purposes of computing cash flows. Use these relative inflation rates to forecast both expected future spot rates and the foreign cost of capital. Now convert foreign cash flows into domestic currency at expected future spot rates and then discount in the domestic currency. Are the NPVs the same?

Part 2 -

1. Suppose the inflation rate is expected to be 4% in each currency. Inflate the cost projections in Exhibit 2 at these rates and repeat the valuation in 1. How much is the increase in value under the two approaches? Where does it come from?

2. Consider the last paragraph of the case (before the exhibits). Instead of the peseta appreciating against the dollar as some experts think, suppose a different currency expert thinks the peseta is going to lose value against the dollar due to a crisis associated with upcoming Spanish elections. In particular, he believes the peseta will fall from its current value of Pts127/$ to Pts150/$ next year, Pts170/$ in the second year, and will then remain at Pts170/$ indefinitely. This represents a possible (and serious for Merck) deviation from UIP. Repeat the valuation in 1a and 1b. What do you find?

3. Suppose real interest rates in Spain and the U.S. are not in equilibrium, and that the weighted average cost of capital on projects of this risk in Spain is 25% rather than the rate suggested by the inflation differential. Expected future spot rates are still generated assuming PPP holds: E[StPts/$]/S0Pts/$ = [(1+E[pPts])/(1+E[p$])]t.

4. What does Section 13-3 of the text say about whether you want to hedge the project's cash flows against currency risk in each of the above scenarios?