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Case 2 : Integration of Movements in Prices, Inflation, and Exchange Rate Cambridge Resources International Inc. 2 0 2 2 1 INFLATION, EXCHANGE RATES AND

Case 2: Integration of Movements
in Prices, Inflation, and Exchange
Rate
Cambridge Resources International Inc. 20221
INFLATION, EXCHANGE RATES AND INTEREST RATES
Assume the domestic rate of inflation in South Africa has been 6 percent per year
for the past three years, but the rate is expected to decrease by 0.5 percentage points
each year for the next two years until it reaches 5 percent. Then, it is expected to
remain at that level in the future. The inflation rate in Japan has been 1 percent per
year last year, but the rate is expected to decrease by 0.2 percentage point each year
for the next three years until it reaches 0.4 percent. Then it is expected to remain at
that level in the future. The price index for both South Africa and Japan in year 1 is
1.
The currency of South Africa is the Rand and that of Japan is the Yen. Assume that
the market exchange rate in Year 1 is 0.10Rand/Yen.
The nominal one-year interest rate for Rand loans is 9.72 percent as of Year
1, with an expectation that the rate of inflation will be 5.5 percent the next year.
Assume that the real exchange rate between the two countries will remain at the
same level until Year 7.
Assignment:
Prepare a table that contains the following information:
1. The projected price index for South Africa from Year 1 to Year 7.
2. The projected price index of the Japan from Year 1 to Year 7.
3. What is the real exchange rate as of Year 1?
Cambridge Resources International Inc. 20222
4. Using the assumption that the real exchange rate remains constant over the
future 7 years, what are the projected nominal exchange rates between Year 2
and Year 7?
5. What is the real rate of interest as of Year 1 in South Africa?
6. Assuming that the real rate of interest remained constant over the next 7 years,
forecast the annual nominal interest rates in South Africa that would be
consistent with the real rate of interest and the projected rates of inflation?
7. Suppose the world price of a Personal Digital Assistant (PDA) that South
Africans buy from Japan is 10,000 Yen per unit in Year 1. It is expected that
the real price of PDAs will decrease by 10 percent a year, from Year 2
onward, for the following 7 years. What do you expect it to cost to South
African consumers in Rand price (nominal) in Year 6?
8. Suppose a South African firm obtained a 2.5 million Rand loan in Year 2, and
the loan principal is to be repaid in equal installments over the following 5
years. The interest accrued over the previous year is also paid in the current
year. What would be the amount of interest expense paid each year over this
five-year period, expressed in the prices of Year 2? Estimate the annual tax
savings per year (i.e. in Year 2 prices) that will accrue to this company given
that it is subject to a corporate flat tax rate of 40%. What would be the annual
savings under conditions of an expected rate of inflation of zero over the entire
period? Compare and comment on the differences in tax saving of the withand-without-inflation situation and the impact on the financial net present
value (NPV) of the activity. The real discount rate is 4%.
Cambridge Resources International Inc. 20223
9. Suppose that instead of the real exchange rate between the Rand and the Yen
being held constant over time, it is expected that the Yen will appreciate
relative to all other currencies, including the Rand, by 2 percentage a year
over the period from Year 2 to Year 7. What would you expect the real and
nominal interest rates now to be from Year 2 until Year 7 on a Japanese Yen
loan made to the same South African business as described in question 8?
What is the amount of real interest expense measured in Rand expressed in
the price level of Year 2 for an equivalent Yen loan that is equivalent in value
to 2.5 million Rand in Year 2? What is the annual value of the foreign
exchange capital gain or losses associated with this foreign (Japanese) loan
over its repayment time?
10.Suppose, again, that this South African company has the following cash flow
profile, and that accounts receivable are estimated to be at 50% of sales,
accounts payable to be at 10% of operating costs (material purchases + direct
labor costs), and cash balances to be at 10% of sales.
Cambridge Resources International Inc. 20224
Year 2 Prices Real Cash flow (Rand)
Year 2345678
Sales
revenues 3,500,0003,500,0003,500,0003,500,0003,500,0003,500,000
Material
purchases 1,200,0001,200,0001,200,0001,200,0001,200,0001,200,000
Direct
labor costs 40,00040,00040,00040,00040,00040,0000
a. Using a real discount rate of 4%, and calculating the present values of the
following cash flow items, evaluate their impact on the cash flow statement
of this company under the condition of zero inflation and under the condition
of 10% annual constant inflation rate
Cash balances
Accounts payable
Accounts receivable
b. Using the first-in-first-out (FIFO)

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