Gaudi Ltd is a local Australian company. Gaudi Ltd is considering a new project with a different risk profile to its main operations. That is, the new project has a higher level of risk than their existing projects.
 

The project involves purchasing new equipment from a Japanese supplier. The purchase contract for the new equipment requires two payments—a down payment of ¥7,000,000 in year 0 and another payment of ¥25,000,000 at the end of year 1. The current spot exchange rate is AUD0.012/¥.
 

In additional to the payment of equipment, the other expected incremental after tax cash flows of the project are given below:
 

Year      Project
1           $190,000
2          $200,000
3          $180,000
4          $200,000
The corporate treasurer has concluded that the following certainty equivalent coefficients apply to each of the risky cash flows for the project:
Year Project
0       1.00
1        0.96
2       0.92
3       0.84
4       0.78
The current risk-free rate for Australian dollars is 2.23% per annum. The current risk-free rate for Japanese yen is 0.80% per annum. Gaudi's cost of capital is 12%. Gaudi's treasurer thinks that the riskiness of this new project warrants a 4.00% risk premium

 

a. Calculate the arbitrage-free one year forward exchange rate.

 

b. Gaudi could hedge this exchange rate risk using a cash-and-carry strategy. Describe the steps necessary to implement such a cash-and-carry strategy.

 

c. Convert the yen-denominated payments to Australian dollars.

 

d. Suppose Gaudi enters into a currency forward contract to hedge its foreign exchange risk associated with the payment due in one year. Estimate the net present value of the project using the certainty equivalent method. Should the firm undertake the project?