FOREIGN CAPITAL BUDGETING Solitaire Machinery is a Swiss multinational manufactur- ing company. Currently, Solitaires financial planners are considering undertaking a 1-year project in the United States. The projects expected dollar-denominated cash flows consist of an initial investment of $1,000 and a cash inflow the following year of $1,200. Solitaire estimates that its risk-adjusted cost of capital is 12%. Currently, 1 U.S. dollar will buy 0 90 Swiss franc. In addition, 1-year risk-free securities in the United States are yielding 5%, while similar securities in Switzerland are yielding 3 25%.

a) If this project was instead undertaken by a similar U.S.-based company with the same risk-adjusted cost of capital, what would be the net present value and rate of return generated by this project?

b)What is the expected forward exchange rate 1 year from now?

c) If Solitaire undertakes the project, what is the net present value and rate of return of the project for Solitaire?

ANSWER:

a) Net Present Value and IRR if project undertaken by US Company
	Year	Cash flows	Factor (12%)	PV of CF
	0	-$1,000	1.000	-1000
	1	$1,200	0.893	1071.43
	Net Present Value			$71.43
		Let IRR =	Y
		1000 = 1200/ (1+y)
		Y = (1200/1000)-1
		y = 1.2-1
		Rate of Return		20%
b) Expected Forward Exchange Rate
	Forward Exchange Rate:		Forward Exchange Rate			=	1+rSwiss
			Spot Exchange Rate				1+rus
			Forward Exchange Rate			=	1+3.25%
			0.9				1+5%
			Forward Exchange Rate			=	1.0325
			0.9				1.05
			Forward Exchange Rate			=	0.9833
			0.9
				Forward Exchange Rate		=	0.9833*0.90
						=	0.885
	Therefore, 1 year forward exchange rate
		1 USD = 0.885 Swiss Francs
		Or 1 Swiss France = 1/0.885 =			1.13	USD
c) NPV and IRR for Solitaire
	First cash inflows and outflows will be adjusted in Swiss currency
		Year	Cash flows	CF (Swiss)	Factor (12%)	PV of CF
		0	-$1,000	-900	1.000	-900
		1	$1,200	1,062	0.893	948.21
		Net Present Value (Swiss Franc)				48.21
			Cash Inflow =	1,000* 0.90 = 900		Swiss Franc
			Cash Outflow = 1,200*0.855 = 1,062 Swiss Franc
			IRR=	(1,062/900)-1
			=	1.18-1
			IRR =	18.00%

PLEASE EXPLAIN STEP BY STEP WHY WE USE THESE FORMULAS AND HOW TO USE THE FORMULAS TO SOLVE EACH PART OF THE QUESTION (a, b, c) USING WORDS (VERBAL RESPONSE)