RSR FINANCE 680 -Global Financial Policy Fall, 2014
WB 353
PROBLEM SET # 3 Total points: 35

1. If you invest US$1,000 in Brazilian Real bond for 1 yr paying 8.5%t interest. At the time you bought the Brazilian Real bond, the exchange rate was US$.0.390 per Brazilian Real.
4 Points


a) If 1 year later you convert the maturity value of the investment in Brazilian Real to US dollars, the exchange rate was US$ 0.415 per Brazilian Real, compute the effective rate of return in US dollar terms.

b) If 1 year later you convert the maturity value of the investment in Brazilian Real to US dollars, the exchange rate was US$ 0.380 per Brazilian Real, compute the effective rate of return in US dollar terms.


2. ABC Corporation has 90-day payables of Euro 200,000. The following information is available: 6 Points

Spot rate of the Euro: US$ 1.25 per Euro
90-day Forward Rate: US$ 1.20 per Euro

90-day Interest rates are as follows:
US Euro

90-day deposit rate 3.0 % 4.0 %
90-day borrowing rate 5.0 % 6.0 %

A call option on Euro that expires in 90-days has an exercise price of $ 1.25, and has a premium of $ 0.05. A put option on Euro that expires in 90-days has an exercise price of . 1.25., and has a premium of $. 0.04

The Euro spot rate in 90-days is forecasted to be:


Possible Rate Probability

US$ 1.25 40 %
US$ 1.15 60 %
ABC Corporation is considering:

a) a forward hedge
b) a money market hedge
c) an option hedge and
d) remaining un-hedged

You have been hired as a consultant to decide on the best possible hedge. Which one of the alternatives you will recommend, and why?

3. Another US corporation (XYZ Corporation) has Euro 300,000 in 90-day receivables. It is considering: 6 Points

a) a forward hedge
b) an option hedge
c) money et hedge and
d) remaining un-hedged

Using the information in problem # 2, recommend which one of the three alternatives, XYZ Corporation should choose, and why?

4. Capital Budgeting Problem 19 points

INDU FOOD PRODUCTS- CASH FLOW ESTIMATION & CAPITAL BUDGETING


Indu Food Products, a wholly-owned Indian subsidiary of US MNC "HealtyYou", is considering expansion of its healthy natural drinks; the product being considered is "LoveMeTender" fresh tender coconut water! You have been hired as a consultant to the project and you are required to evaluate the new project.

The coconut water will be produced in an unused building adjacent to its Mumbai Airport, Mumbai, Bombay, India; Indu owns the building which is fully depreciated. The required equipment would cost Rs. 200,000, and an additional Rs.40,000 will be needed for shipping and installation. In addition, the required inventories would rise by Rs. 50,000 while accounts payable would go up by Rs. 25,000. All of these costs will be incurred at time 0. The machinery would be depreciated under the 3-year property MACRS system, with the applicable tax rates of 33%, 45%, 15% and 7% in years 1 through 4.

The project has an economic life of 4 years at which time the project will be terminated; at that time, the project is expected to have a salvage value of Rs. 50,000 net of any taxes.

Unit sales are expected to be total 100,000 cans per year with a price of Rs. 225 per can; variable operating costs excluding depreciation are estimated to be 60% of the sales for a given year. Indu is in the 40% tax bracket. This coconut water project is assumed to be have the same risk as existing projects.

The risk-free rate of return is 4%; return on the market (S & P 500 Index return) is 12%; the beta of the Indu's stock is 1.25.

Indu's capital structure consists of Rs. 600 million debt and Rs. 400 million in equity, and the before-tax cost of debt is 10%.

The exchange rate is expected to remain steady at Rs. 60 per US $.

Questions:

1. Please calculate the Cost of equity using Security Market Line (SML) equation of the Capital Asset Pricing Model (CAPM).
2. Calculate the after-tax cost of debt.
3. Calculate the Weighted Average Cost (WACC) of capital for the current capital structure.
4. Calculate the Net Investment Cost (NINV) at time t=0 in US $.
5. Calculate the Incremental after-tax cash inflows in years 1 through 4 also in US $s. (Hint: Please drive the Annual Revenues or Sales as # of Cans sold * price per can & go from there1)
6. Using the WACC as the discount rate, calculate the NPV of the project. Should the project be accepted? Why or why not?
7. Now, suppose the project is (more) riskier than the existing projects and requires additional 4% risk premium on the top of the WACC. Calculate the Risk-Adjusted Discount Rate (RADR).
8. Using RADR, calculate the NPV of the project. Should the project be accepted now? Why or why not?
9. Some of the money used to finance the project will be raised through debt. The firm expects a payment of Rs. 30,000 in interest expense per year on account of this debt. Given this information, do you think that the cash flows of the project be revised to incorporate this interest expense? Please (just) explain.
10. If the sales of the existing fresh orange juice of Indu would be reduced by Rs. 35,000 per year because of the introduction of this coconut water project, how would you account for this "Cannibalization Effect?" Please re-calculate your NPV for questions 6 and 8 above.

11. Now, suppose, the exchange rate is no longer steady; It is expected to be either strong or weak:
a) Strong Rupee Scenario

Year 1 2 3 4
Rate Rs. 60/US $ Rs. 57.5/US $ Rs. 55/US $ Rs. 52.5/US $

b) Weak Rupee Scenario

Year 1 2 3 4
Rate Rs. 60/US $ Rs. 62.5/US $ Rs. 65/US $ Rs. 67.5/US $

Please re-estimate the $ cash inflows and recalculate the NPV's in scenarios 6 and 8 above.

12. Please summarize your findings, and recommend whether or not the "LoveMeTender" coconut water project should be accepted, or not?