A German company manufactures a specialized piece of manufacturing equipment and leases it to a U.K. enterprise.

Question:

A German company manufactures a specialized piece of manufacturing equipment and leases it to a U.K. enterprise. The lease calls for five end-of-year payments of £1 million. The German firm spent €3.5 million to produce the equipment, which is expected to have no salvage value after five years. The current spot rate is €1.5/£. The risk-free interest rate in Germany is 3 percent, and in the United Kingdom it is 5 percent. The German firm reasons that the appropriate (German) discount rate for this investment is 7 percent. Calculate the NPV of this investment in two ways.

a. First, convert all cash flows to pounds, and discount at an appropriate (U.K.) cost of capital. Convert the resulting NPV to euros at the spot rate.

b. Second, calculate forward rates for each year, convert the pound-denominated cash flows into euros using those rates, and discount at the German cost of capital. Verify that the NPV obtained from this approach matches (except perhaps for small rounding errors) that obtained in part (a).

Salvage Value
Salvage value is the estimated book value of an asset after depreciation is complete, based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important... Discount Rate
Depending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal...