Ace, Inc., a US company, has been approached by Lakson Group, a company from Pakistan, to explore the possibility of a joint venture to produce widgets in Pakistan. Ace is currently exporting widgets to Pakistani importer SS Import-Export Co., but since the current export agreement it has obtained from the Pakistani government is about to expire, Ace is interested in exploring the opportunity to join forces with Lakson. Ace estimates that the joint venture's annual sales in Pakistan will be 15,000 widgets. The spot exchange rate is 10 Pakistan rupees (PKR) per $1.

Production of widgets in Pakistan requires the purchase of a plant at a cost of 600,000 PKR and a 100,000 PKR investment in net working capital, both costs to be equally shared by the two firms at the launch of the joint venture (i.e., at t=0). The plant will be depreciated on a straight-line basis over 8 years. The total cost of production in Pakistan is currently estimated to be 23 PKR per widget and is expected to remain unchanged over the following three years. Part of this cost is for components produced by Ace using a proprietary technology in the US; each component costs Ace $0.5 to produce and it is then supplied (i.e., sold) to the joint venture plant in Pakistan at $0.7. Production of each widget requires one of these proprietary components. SS Import-Export has agreed to buy the widgets produced in Pakistan over the next three years at 50 PKR per widget. The applicable tax rate in Pakistan and in the US is 35%.

Three years after the joint venture is established, Ace will pull out and in return it will recover in full its investment in net working capital and it will also sell its share of the plant to Lakson for an amount equal to 110% of its share of the plant's book value at that time. To promote investment by US firms in Pakistan, the US government has agreed that the sale of Ace's share of the plant to Lakson three years from now will have no tax implications. In addition, the Pakistani government has agreed that at the end of each of the first three years, Ace may remit its share of the joint venture's net cash flows to the US at the exchange rates expected to prevail.

You are in charge of evaluating the joint venture for Ace. You believe that projects similar to the one described above would require a 12% rate of return if undertaken in the US. Further, your assistant has provided the following input about the projected inflation rates over the next three years:

Year

1

2

3

US

1%

1%

2%

Pakistan

3%

4%

6%

1. The table below provides Ace's t = 2 net cash flows at t = 2 which consist of 50% of the cash flow generated from the operations in Pakistan by the joint venture and 100% of the cash flow generated from supplying the proprietary components. In addition, the table provides the t = 0 spot exchange rate and the t = 2 expected spot exchange rate.

Year

0

1

2

3

Ace's net cash flow from components ($)

NA

?

1950.00

?

Ace's net cash flow from operations in Pakistan (PKR)

?

?

144750.00

?

Indirect exchange rate (PKR/$)

10

?

10.501

?

1. Calculate Ace's $-denominated net cash flows from components at t = 1 and t = 3. What is the NPV (at t = 0) of Ace's net cash flows from components from t = 1, 2 and 3?