25 Capital budgeting analysis. Zistine plc considers a one-year project in New Zealand so that it can capitalize on its technology. It is risk-averse, but is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible UK bank. The cash flows earned on the project will be converted to British pounds and remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is 8% while the nominal one-year interest rate in the United Kingdom is 2%. Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect (IFE). He also believes that interest rate parity holds. He provides this information to three recent finance graduates that he just hired as managers and asks them for their input.

a The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a forward contract or are not hedged. Is this manager correct? Explain.

b The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.

c The third manager states that the project should be hedged because the forward rate contains a premium and, therefore, the forward rate will generate more British pound cash flows than the expected amount of cash flows if the firm remains unhedged. Is this manager correct? Explain.