Question 21.A.4: International Capital Budgeting PROBLEM: A U.S. electronics...
International Capital Budgeting
PROBLEM: A U.S. electronics firm is establishing a manufacturing plant in Taiwan to produce components that will be sold to customers in Taiwan. The cost of the investment is $10 million. The project is expected to last five years and then shut down. The company usually uses a discount rate of 7.5 percent for domestic projects like this, but for this project, the financial manager adds a 2.5 percent country risk premium. The following time line shows the expected cash flows in millions of Taiwanese dollars (TWD) and the forecasted year-end exchange rates between the U.S. dollar and the Taiwanese dollar.
Cash flows (millions of TWD)
Expected exchange rate (TWD/$)
What is the NPV of this project?
APPROACH: Since we know the expected cash flows in the foreign currency and the expected exchange rates, we can calculate the expected cash flows to the parent firm in U.S. dollars by dividing the TWD cash flows by the appropriate exchange rate. We also must adjust the project discount rate for the 2.5 percent country risk premium.
The following table shows the conversion of the cash flows the U.S. firm expects to receive from Taiwanese dollars to U.S. dollars.^3
| Year | Cash Flows (TWD millions) | Exchange Rate | Cash Flows ($ millions) | ||
| 0 | −$10.00 | ||||
| 1 | 64.3 TWD | ÷ | 32.031 TWD/$ | = | 2.01 |
| 2 | 71.2 | ÷ | 33.632 | = | 2.12 |
| 3 | 93.6 | ÷ | 36.155 | = | 2.59 |
| 4 | 121.8 | ÷ | 32.221 | = | 3.78 |
| 5 | 109.6 | ÷ | 33.670 | = | 3.26 |
The appropriate discount rate is 2.5 percent over the discount rate that the firm normally uses for domestic capital budgeting projects. Thus, the discount rate to be used is 10 percent (2.5 + 7.5 = 10). By discounting the cash flows at the risk adjusted discount rate of 10 percent, we can compute the NPV for this project.
\begin{matrix} NPV &=& -\$10.00+\frac{\$2.01}{1.10}+\frac{\$2.12} {(1.10)^2}+\frac{\$2.59}{(1.10)^3}+\frac{\$3.78}{(1.04)^4}+\frac{\$3.26}{(1.10)^5} \\\\ &=& -\$10.000 + \$ 1.83 + \$ 1.75 + \$ 1.95 +\$ 2.58 +\$2.02 \\\\ &=& \$0.13 \ million\end{matrix}Since the NPV is positive, the project should be accepted.