Please explain why is the above formula is applied in the working? According to
ID: 2784081 • Letter: P
Question
Please explain why is the above formula is applied in the working? According to the below solution, it wrote that it is using both combination of interest rate parity(IRP) and purchase power parity(PPP) formula. How to get the above formula using IRP and PPP?
C12/Q14 Capital Budgeting Lakonishok Equipment has an investment opportunity in Europe. The project costs 19 million and is expected to produce cash flows of 3.6 million in Year 1,4.1 million in Year 2, and 5.1 million in Year 3. The current spot exchange rate is $1.09/ and the current risk-free rate in the United States is 3.1 percent, compared to that in Europe of 2.9 percent. The appropriate discount rate for the project is estimated to be 10.5 percent, the U.S. cost of capital for the company. In addition, the subsidiary can be sold at the end of three years for an estimated e12.7 million. What is the NPV of the project?Explanation / Answer
The firm which is looking to invest in the opportunity is based in US. So dollar is the relevant currency in which the firm should evaluate the project .The project is located in Europe.so all cash flows are in euro. And for each year the euro dollar exchange rate is likely to vary in the coming period. For which we calculate the expected exchange rate for each of the year using spot exchange rate. This expected exchange rate is used to convert the cash flow in euros into dollar for the firm to analyze the NPV of the project . The discount rate to evaluate will still remain 10.5% as US cost of capital.
Yr cash flow. Rate. Pv
0. 20710000. 1. -2017000
1. 3931626. 0.9049. 3558033
2. 4486389. 0.8189. 3674281
3. 19515351. 0.7411. 14464037
Total $19679351
The project should be accepted as NPV is positive