Question
12. 12.Maryland Light, a U.S. light fixtures manufacturer, is considering an investment in Japan. You are in the corporate finance department and are responsible for
12.
12.Maryland Light, a U.S. light fixtures manufacturer, is considering an investment in Japan. You are in the corporate finance department and are responsible for deciding whether to undertake the project. The free cash flows, in Japanese yens, are uncorrelated to the spot exchange rate and are forecast to be as shown below:
Year Free Cash Flow ( million)
0 28
1 14
2 12
3 15
The new project has similar dollar risk to Maryland Lights other projects. The company knows that its overall dollar WACC is 11%, so it feels comfortable using this WACC for the project. The risk-free interest rate on dollars is 5%, and the risk-free interest rate on Japanese yens is 1%. The spot exchange rate is S=110/$. Maryland Light is willing to assume that capital markets in the United States and Japan are internationally integrated.
a. What is the company's yen WACC? (2 marks)
b. What is the net present value of the project in Japanese yens? What is the net present value of the project in USD? Should Maryland Light undertake the project? (4 marks)
c. Your colleague suggests that the method of calculating dollar NPV by converting the yen NPV at the spot rate that you have used in part (b) is inaccurate. Instead, he suggests that it is more appropriate to convert the yen cash flows into dollars and then calculate the NPV of these dollar cash flows using dollar WACC. Do you agree with your colleagues suggestion? Why? (2 marks)
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