Reference no: EM132545487

Questions -

Q1. ABC Ltd, a U.K. multinational enterprise is contemplating making a foreign capital expenditure in South Africa. The initial cost of the project is ZAR50 million. The annual cash flows over the five-year economic life of the project are estimated to be ZAR13 million, ZAR18 million, ZAR25 million, ZAR10 million, and ZAR9 million. ABC Ltd's cost of capital in pounds (£) is 7.5 percent. The long-run inflation rate is forecasted to be 4 percent per annum in the U.K. and 12 percent in South Africa. The current spot foreign exchange rate is ZAR/£ = 15.56.

Required:

(a) Calculate the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher Effect and then convert the ZAR NPV to £ at the current spot exchange rate.

(b) Convert all cash flows from ZAR to £ at Purchasing Power Parity forecasted exchange rates and then calculate the NPV at the pound cost of capital.

(c) What is the NPV in pounds if the actual pattern of ZAR/£ exchange rates is: S(0) = 15.56, S(1) = 14.56, S(2) = 16.72, S(3) = 15.78, S(4) = 16.54, and S(5) = 16.32? Explain the difference in the actual and the forecasted NPV.

Q2. Assume that Jarret Co. (a U.S. firm) expects to receive 1 million euros in 1 year. The spot rate of the euro is $1.20. The 1-year forward rate of the euro is $1.21. Jarret expects the spot rate of the euro to be $1.22 in 1 year. Assume that 1-year put options on euros are available, with an exercise price of $1.23 and a premium of $0.04 per unit. Assume the following money market rates:

United States Eurozone

Deposit Rate 8% 5%

Borrowing Rate 9% 6%

(a) Determine the dollar cash flows to be received if Jarret uses a money market hedge. (Assume Jarret does not have any cash on hand).

(b) Determine the dollar cash flows to be received if Jarret uses a put option hedge.