Consider the Vino project described in Exhibit T13.2. Suppose the government of Vino offers you a three-year,

Question:

Consider the Vino project described in Exhibit T13.2. Suppose the government of Vino offers you a three-year, subsidized, nonamortizing V500, 000 loan if (and only if) you undertake the wine production investment. Assume they offer you an attractive loan rate of 12.2% even though corporate debt on similar investments yields 15% in vino-unit currency.
a. What is the effect of this offer on the vino-unit NPV of the project?
b. Suppose that the Vino government offers you the same loan regardless of whether you invest in the wine production project. What course of action would you take?
Exhibit T13.2
Wine production in Vino
U.K. Vino
Nominal risk-free government T-bill rate iF£ = 7.1% iFV =12.2%
Real required return on T-bills qF£ = 2.0% qFV = 2.0%
Expected future inflation p£ = 5.0% pV = 10.0%
Real required return on wine production i£ = 12.0% iV = 12.0%
Current spot = V10/£
The following information is known about the project:
• The project has a 3-year life. Assume all operating cash flows occur at year-end.
• An investment of V800, 000 will purchase the vineyard. Its real value will remain constant throughout the investment's life and the vineyard will be sold at the end of the project.
• The winery and wine presses will cost V425, 000. In addition, the wine press supplier has given price quotes of V47, 500 and V27, 500 for the machinery's installation and modification, respectively. All cash outlays are payable at the start of the project.
• Annual depreciation for winery and wine presses is 33%, 45%, 15%, and 7% over the four-year project. (This happens to be identical to 3-year ACRS in the United States.) The winery and presses are expected to have a total market value of V45, 000 in nominal terms at the end of the project's life in three years.
• No investment in net working capital is necessary. All of the business's transactions are conducted in cash, and just-in-time inventory control will be used.
• Annual sales revenues are expected to be V700, 000, V800, 000, V900, 000 in nominal terms over the next 3 years. Variable operating costs are 10% of sales. Fixed costs are V5, 000 each year in nominal terms.
• Income and capital gains taxes are 50% in each country.
Exchange Rate
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