Reference no: EM133071411

XYZ Company from Australia is evaluating a proposal from its British subsidiary ABC to build a new plant in the United Kingdom. The expected after-tax nominal cash flows in (thousands of) pounds are as follows:

The current spot rate is 1.80A$/£. The firm's tax rate is 30%. The firm's pre-tax cost of debt in Australia is 8%; the firm's debt-to-equity ratio is 2; the beta of the firm's common stock is 1.25; the market risk premium is 8%, the yield of the long term Australian Treasury bond is 6%.  Assume the term structure is flat.

a. ABC forecasts that over the next three years, the expected inflation for UK and Australia are 2% p.a. and 5% p.a. respectively and it believes PPP holds. Would ABC recommend going ahead with the project or not based on this information? Show the detailed calculation to justify the recommendation.

b. Separately, the board of XYZ, is worried about the consequences of uncertainty associated with the Brexit. It seeks the consultation of Professor Markt. Prof. Markt points out that over the next three years, the interest rates for UK and Australia are 3% p.a. and 4% p.a. respectively and he believes that uncovered interest rate parity relationship holds. Would the board recommend taking on the project or not based on this information? Show the detailed calculation to back up the recommendation.

c. The board looks at the two recommendations and wants to make sense of two results. Discuss the reasons why they are the same or different.