1. Calculate the net present value of Ariel-Mexico recycling equipment in pesos by discounting incremental peso cash flows at a peso discount rate. How should this NPV be translated into Euros? Assume expected future inflation for France is 3% per year.
2. Compute NPV in Euros by translating the project future peso cash flows into Euros at expected future spot exchange rates. Note that Ariel's Euro hurdle rate for a project of this type was 8%. Again, note that annual inflation rates are expected to be 7% in Mexico and 3% in France.
3. Can you find a relationship between the answer to question 1 and 2?Is it a coincidence?
4. Suppose Mexican inflation is projected at 3% instead of 7% per year (assume French inflation remains at 3%). How does this affect the NPV calculations?
5. Should Groupe Ariel approve the equipment purchase? What if Ariel expects a significant real depreciation of the peso against the Euro?

4194 APRIL19,2010 T I M O T H YA. LU E H R MAN JAM ES QUIN N Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation On June 23, 2008, a Monday morning, Arnaud Martin arrived at his office in Groupe Ariel's corporate headquarters in Mulhouse, France. The previous week, Martin had requested additional financial information about an investment proposal from Ariel-Mexico, a wholly owned subsidiary that operated a manufacturing facility and a regional sales office in Monterrey, Mexico. The information had arrived late Fridaytoo late for Martin to analyzeand was waiting for him Monday morning. As a financial analyst for a global manufacturer of printing and imaging equipment, Martin examined many cross-border projects, particularly since Ariel had accelerated its move into emerging markets several years earlier. The Mexican investment proposal called for the purchase and installation of new automated machinery to recycle and remanufacture toner- and printer cartridges. Cartridge recycling had become an important part of Ariel's business in many markets and promised continued growth. Many office product retailers operated formal toner cartridge recycling programs, for both the environmental benefits of keeping materials out of landfills and demonstrated cost savings for their customers. Writing in a leading trade journal, one analyst predicted, \"We are going to see more and more refined approaches to recycling and remanufacturing [cartridges] in the coming months and years ... Both corporate and individual consumers are becoming habituated to it. They have simply come to expect recycling as an option, even for smaller cartridges at lower price points.\" Ariel-Mexico's Monterrey plant began its cartridge recycling program in 2005. The plant's recycling process consisted of a sequence of operations carried out almost entirely by hand, with the help of hand tools and a simple machine. The investment proposal called for replacing this process with new automated machinery from Germany that cost an estimated 3.5 million pesos (approximately 220,000) fully installed. As described in the project summary, Ariel-Mexico expected to realize substantial savings in labor and materials almost immediately. Though the proposed expenditure was relatively small, Ariel required a discounted cash flow analysis for all such investments in its newer foreign markets and a review by corporate headquarters in Mulhouse. ________________________________________________________________________________________________________________ 4194 | Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation Martin was assigned to perform an analysis of the investment proposal and make an \"up or down\" recommendation to his superior by Wednesday morning. Groupe Ariel S.A. Groupe Ariel was a global manufacturer of printers, copiers, fax machines, and other document production equipment. The company also provided consulting and document outsourcing services, with after-sales service contracts constituting about 18% of overall revenue. Company sales for 2008 were projected to be 3.35 billion, down from 2007 due to a global recession. Operating profit was expected to be 61.2 million in 2008, and the company projected a small net loss for the year. Exhibit 1 presents selected consolidated financial data for Groupe Ariel. Ariel's low profitability was typical of the industry in 2008; all of its competitors were similarly affected by the recession. One bright spot in the company's outlook, however, was its growth in several emerging markets, including the so-called BRIC economies of Brazil, Russia, India, and China. Ariel had been a global firm for years, but did not move aggressively into emerging markets until 2003-2004. This was later than some of its competitors. On one hand, this meant Ariel's market share lagged in some markets. On the other hand, Ariel avoided some of its competitors' earlier mistakes. The company's international operations were conducted primarily through a large network of subsidiaries, which operated mostly medium-sized regional factories in which printers, copiers and other products were manufactured to suit local tastes. Ariel conducted business in 28 countries around the world, with operations consisting of manufacturing facilities, small research labs, as well as sales and marketing subsidiaries. In 2008, subsidiaries outside the European Union recorded about half of Ariel's sales and generated slightly less than 40% of pretax income. Ariel competed in a relatively mature market, and its chief competitors were both established multinational companiessome of which had developed their consulting and other after-sales services businesses to a higher level than had Arielas well as smaller players serving niche markets. While Ariel marketed and sold its products across the full spectrum of industries, it had enjoyed particular success in financial services, health care, and government sectors. Operations in Monterrey: Ariel-Mexico According to Ariel's CEO Alphonse Helmont, \"We were attracted to Mexico for the same reason we built operations in Brazil and other emerging markets. We wanted to diversify our operations and believed we needed to establish a strong presence in places besides Europe and the United States.\" He added: \"Certainly there is risk [in these countries], but their economies are dynamic and Ariel must be present. ... You can see our competitors feel the same way!\" A key characteristic of Ariel's printing and imaging products was their durability, which Ariel's executives felt conveyed a competitive advantage in emerging economies where Ariel positioned equipment as offering a lower total cost of ownership. In particular, the company's marketing material claimed a working life 10 months longer than its closest competitor, with 30% lower service costs. CEO Helmont observed: \"We demonstrate to our customers that we have a local presence and we are the lowest total-cost provider. This creates loyalty and solid market positions in Mexico and other of our newer markets.\" The manufacturing facility in Monterrey was located near a small research and design facility, also owned by Ariel. While many product specifications for Ariel's equipment were formulated at the 2 Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation | 4194 corporate offices in Mulhouse, France, it was customary for regional subsidiaries to conduct fine-tuning research and design activity to tailor the product more closely to local consumers' preferences. Thus, it was common for a popular printer or fax machine whose basic design was conceived in Mulhouse to be \"localized\" for size, color, weight, and/or range of features by local design staff. Most of the products produced in the Monterrey plant were sold in Mexico and were distributed through large office-product retailers, department 1 stores, as well as small specialty shops. Manufacturing inputs were sourced locally, and virtually all of the plant's employees were Mexican citizens. In the summer of 2008 gross output at Ariel-Mexico was running at only about 80% of planned capacity. Nevertheless, plant records indicated that there was a sizable increase in demand for recycled printer and toner cartridges. Ariel-Mexico's Programa de Reciclaje de Cartuchos (\"Cartridge Recycling Program\") was started in 2005 to provide low-cost recycling services to all its distributors and customers. Under the terms of users' service contracts, when cartridges reached the end of their useful lives, they could be returned to the Ariel facility in exchange for a significant discount on the purchase of a like number of new cartridges. Ariel pledged to recycle and remanufacture all returned toner and printer cartridges. Ariel-Mexico also had voiced its support for political efforts to pass legislation that would mandate recycling of printing cartridges used by most Mexican businesses and government offices. In 2009 the company planned to launch a pilot program to recycle selected competitors' cartridges. As the number of cartridges returned for recycling increased, Ariel-Mexico management needed to hire and train more employees to carry out the hole-piercing, drilling, vacuuming, and toner/ink evacuation required to recycle cartridges. \"It's taking more and more of my payroll to handle recycling,\" said Ernesto da Silva, the Monterrey plant manager. \"We're happy to see the cartridges coming back in, but the extra volume will become a problem when other operations return to full capacity.\" Cost Savings from the Proposed New Equipment The new equipment could process the Monterrey plant's projected volume using four employees rather than 10, resulting in savings of both direct labor and training costs. Under very favorable circumstances, only three workers would be required. It would also eliminate some human error, which currently resulted in cracked or damaged cartridges which had to be destroyed rather than reused. The new equipment would occupy significantly less space in Monterrey's over-crowded plant; this space would be freed up for other productive uses. It also would require only minimal maintenance expenditures compared to the equipment it replaced, and no significant change in working capital. Exhibit 2 compares projected operating data for the existing recycling process and the proposed automated process, assuming future Mexican inflation of 7% per year. The new equipment would have a useful life of 10 years and would be depreciated under the straight-line method for both tax and financial reporting purposes. Salvage value was likely to equal disposal costs at the end of the useful life. The manual equipment being replaced was very simple and, properly maintained, would last many more years. In June 2008 it had a book value and tax basis of 250,000 pesos and three years of straightline depreciation remaining. However, its market value was thought to be lower, at about 175,000 pesos. After considering Groupe Ariel's consolidated tax position, Martin determined that his analysis would use Mexico's federal corporate tax rate of 35%. 4194 | Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation Real GDP growth in Mexico was 4.2% in 2004the year in which Ariel built its Monterrey plant. By 2006, Mexico's real GDP had risen 5.1%, but subsequently dropped substantially as global recession arrived. Other macroeconomic data in Mexico, including bond yields, bank lending rates, and the consumer price index exhibited similar patterns in recent years. Exhibit 3 shows selected macroeconomic and financial market data for Mexico. Martin had yet to decide whether to perform the discounted cash flow analysis in Euros or pesos, or indeed, whether NPV would be affected by the choice of currency. Ariel's Euro hurdle rate for such a project, if undertaken in France, would be 8%. However, borrowing costs in France and Mexico were clearly different: French banks' prime rate for Euro loans was 4.99%, while the rate in Mexico on short-term peso loans was about 8.10%. Longer-term peso-denominated corporate bonds were yielding 9.21%, compared with long-term Euro-denominated corporate issues at 4.75%. The spot exchange rate on June 23 was MXN15.99/EUR. Many analysts were on record predicting a real depreciation of the peso against both the U.S. dollar and the Euro over the next five years. For example, one international business publication noted \"[Mexico's] rising external financing requirement and the fading impact of the U.S. stimulus package can only increase pressure on Mexico's currency.\" The article went on to forecast a rise in the MXN/EUR rate to 20.00 by 2011 and upwards of 25.00 in 2013-2018. Selected macroeconomic and financial market data for France are presented in Exhibit 4. Exhibit 1 Groupe Ariel S.A.Selected Consolidated Financial Data (millions of Euros, except as noted) 2008 2007 2006 2005 20 Sales Operating income Net income 3,345.3 61.2 (0.7) 3,561.8 189.2 85.7 3,576.9 172.9 61.2 3,078.9 163.5 88.2 3,05 14 8 Total assets Total debt Equity 2,809.3 660.6 782.6 2,764.9 616.0 819.5 2,899.6 613.0 829.7 3,129.0 578.4 941.0 2,44 50 86 87.6 195.0 17.5 100.0 209.4 20.0 95.1 214.0 19.0 240.9 152.9 48.2 23 15 4 Capital expenditures Depreciation R&D expenditures Earnings/share (Euros) Dividend/share (Euros) Return on sales Return on equity (%) (0.0) 0.7 0.0% -0.1% 1.0 0.7 2.4% 10.5% 0.7 0.7 1.7% 7.4% 1.1 0.7 2.9% 9.4% 4194 -6- 1,680,000 1,797,600 ce Overhead 3,360,000 3,774,960 Ex pt Total hi as Materials/unit 1.1387 1.2185 bit no Direct labor/unit 2.2484 2.4057 2 ted Projected Operating Costs, New Automatic Equipment Co ) m Unit volume (000s) 496 546 pa Assumes 7% Inflation in Mexico Materials 542,223 638,197 ris Direct Labor 524,136 616,909 on Overhead 1,566,211 1,675,846 of Projected Operating Costs, Manual Process Total 2,632,571 2,930,951 Pr Unit volume (000s) oje Materials/unit 1.0932 1.1697 cte Materials Direct labor/ unit 1.0567 1.1307 d Direct Labor Op era tin g Da ta for Di ffe re nt Re cy cli ng Pr oc ess es (th ou sa nd s of pe so s, ex 1,923,432 4,250,785 2,058,072 4,797,366 2,202,137 5,133,182 2,356,287 5,492,505 2,521,227 5,876,980 2,697,713 6,288,369 2,886,553 6,728,555 3,088,611 7,199,553 1.3037 2.5741 1.3950 2.7543 1.4927 2.9471 1.5971 3.1534 1.7089 3.3742 1.8286 3.6104 1.9566 3.8631 2.0935 4.1335 600 660 660 660 660 660 660 660 751,158 726,101 1,793,155 3,270,414 884,113 854,621 1,918,676 3,657,410 946,001 914,445 2,052,983 3,913,429 1,012,221 978,456 2,196,692 4,187,369 1,083,076 1,046,948 2,350,460 4,480,484 1,158,891 1,120,234 2,514,993 4,794,118 1,240,014 1,198,651 2,691,042 5,129,707 1,326,815 1,282,556 2,879,415 5,488,786 1.2516 1.2098 1.3392 1.2945 1.4330 1.3852 1.5333 1.4821 1.6406 1.5859 1.7554 1.6969 1.8783 1.8157 2.0098 1.9427 Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation | 4194 Exhibit 3 Selected Macroeconomic and Financial Market Data for Mexico Year Consumer Price Inflation (%) 2000 2001 2002 2003 2004 2005 2006 2007 9.5% 6.4% 5.0% 4.3% 4.7% 3.3% 4.1% 3.8% Real Growth GDP (%) Year-End Spot Exchange Rate (MXN/EUR) 6.6% -0.3% 0.9% 1.4% 4.2% 3.2% 5.1% 3.3% 9.4 9.5 10.4 12.9 15.3 13.3 14.4 16.2 Source: Mexico Country Reports, Economist Intelligence Unit (EIU) Date 31-Mar-06 30-Jun-06 29-Sep-06 29-Dec-06 28-Mar-07 27-Jun-07 26-Sep-07 31-Dec-07 26-Mar-08 23-Jun-08 Short-Term Bank Lending a Rate JP Morgan Mexico 7-10 Year Corporate b Bonds 7.78% 7.68% 7.50% 7.60% 7.68% 7.82% 7.77% 8.00% 7.94% 8.10% 8.20% 9.35% 8.22% 7.42% 7.50% 7.68% 7.86% 8.17% 7.42% 9.21% 10-year Government c Bonds 8.47% 9.06% 8.24% 7.42% 7.58% 7.19% 7.82% 8.08% 7.49% 9.12% Sources: a Bank of Mexico b Thomson Datastream & CEIC c Global Financial Data 4194 | Groupe Ariel S.A.: Parity Conditions and Cross-Border Valuation Exhibit 4 Selected Macroeconomic and Financial Market Data for France Year 2000 2001 2002 2003 2004 2005 2006 2007 Consumer Price Inflation (%) 1.7% 1.6% 1.9% 2.1% 2.3% 1.7% 1.7% 1.5% Real Growth GDP (%) 4.2% 2.1% 1.1% 0.5% 2.3% 1.9% 2.4% 2.3% Year-End Exchange Rate (MXN/EUR) 9.4 9.5 10.4 12.9 15.3 13.3 14.4 16.2 Source: France Country Reports, Economist Intelligence Unit (EIU) Date 31-Mar-06 30-Jun-06 30-Sep-06 31-Dec-06 31-Mar-07 30-Jun-07 30-Sep-07 31-Dec-07 31-Mar-08 23-Jun-08 Sources: a Thomson Datastream b Thomson Datastream & CEIC c Global Financial Data Short-Term Bank Lending a Rate 3.08% 3.27% 3.63% 4.07% 4.42% 4.69% 4.91% 5.13% 4.81% 4.99% JP Morgan France 7-10 Year Corporate b Bonds 3.73% 4.03% 3.69% 3.96% 4.08% 4.60% 4.36% 4.34% 4.00% 4.75% 10-year Government c Bonds 3.79% 4.08% 3.72% 3.98% 4.11% 4.62% 4.41% 4.42% 4.11% 4.81% Cost of operating manual equipment Cost of operating new equipment Cash inflow Loss on depreciation of old equipement Increased Cash Flow Discount rate Present value of Net cash flow Project net investment Project NPV 2009 2010 2011 2012 3360000 3774960 4250785 4797366 2632571 2930951 3270414 3657410 727429 844009 980371 1139956 161266 202070 249797 476485 566,163 641,939 730,574 663,471 0.1212 $4,667,811 3,325,000 $1,342,811 2013 2014 2015 2016 2017 5133182 5492505 5876980 6288369 6728555 3913429 4187369 4480484 4794118 5129707 1219753 1305136 1396496 1494251 1598848 304414 334298 366274 400488 437097 915,339 970,838 1,030,222.00 1,093,763.00 1,161,751.00 2018 7199553 5488786 1710767 476268 1,234,499 Cash value Net cash outflow Cost of operating manual equipment Cost of operating new equipment Cash inflow Loss on depreciation of old equipement Increased Cash Flow Discount rate Present value of Net cash flow Project net investment Project NPV NCFs (MXN) E St MXN/EUR NCFs EUR Discount rate Net preent value of NCFs Net invest Project NPV Initial capital -3,500,000 175,000 -3,325,000 2009 2010 2011 2012 3360000 3774960 4250785 4797366 2632571 2930951 3270414 3657410 727429 844009 980371 1139956 161266 202070 249797 476485 566,163 641,939 730,574 663,471 0.1212 $4,667,811 3,325,000 $1,342,811 566,163 641,939 16.61 17.26 34085.6712824 37192.29 0.08 $290,870 $207,942 $82,928 730,574 663,471 17.93 18.62 40745.9 35632.17 2013 2017 2018 5133182 5492505 5876980 6288369 6728555 3913429 4187369 4480484 4794118 5129707 1219753 1305136 1396496 1494251 1598848 304414 334298 366274 400488 437097 915,339 970,838 1,030,222.00 1,093,763.00 1,161,751.00 7199553 5488786 1710767 476268 1,234,499 915,339 19.35 47304.34 2014 2015 2016 970,838 1,030,222.00 1,093,763.00 1,161,751.00 1,234,499 20.1 20.88 21.69 22.53 23.41 48300.4 49340.1341 50427.06316 51564.624945 52733.83 Operating cost Old-New Equipment Depreciation old equipment Depreciation New equipment Discount rate Present value of net cash flow Project net investment Project NPV in MXN Project NPV in EURO 727,430 83333.33 350,000 566163 0.08 $4,668,580 3298750 $1,369,830 85,668 812968 908233 1016594 83333.33 83333.33 350,000 350,000 350,000 621762 683685 783286 1047092 1078504 1110860 1144185 1178511 1213866 350,000 803110 350,000 823528 350,000 844559 350,000 866221 350,000 88532 350,000 911513