Problem $18\mathrm{.}10$ Hermosa Components: Revenue Growth, Sales Price, and Currency Risk Scenario

Melinda Deane, a new analyst at Hermosa and a recent MBA graduate, believes that it is a fundamental error to evaluate the Argentine project$$s prospective earnings and cash flows in dollars, rather than first estimating their Argentine peso $($Ps$)$ value and then converting cash flow returns to the United States in dollars. She believes the correct method is to use the end$-$of$-$year spot rate in $2012$ of Ps$3\mathrm{.}50=$ $$1\mathrm{.}00$ and assume it will change in relation to purchasing power. $($She is assuming U$.$S$.$ inflation to be $1\%$ per annum and Argentine inflation to be $5\%$ per annum.$)$ She also believes that Hermosa should use a risk$-$adjusted discount rate in Argentina which reflects Argentine capital costs $(20\%$ is her estimate$)$ and a risk$-$adjusted discount rate for the parent viewpoint capital budget $(18\%)$ on the assumption that international projects in a risky currency environment should require a higher expected return than other lower$-$risk projects. How do these assumptions and changes alter Hermosa$$s perspective on the proposed investment?

Assumptions Value Growth Assumptions Value

Light bulb export volume to Argentina, per year $24,0004\mathrm{.}00\%$ Sales multiple in year $56\mathrm{.}00$

Sales price per set in Argentina $$60\mathrm{.}007\mathrm{.}00\%$ Spot rate, $2003($Pesos$=$US$$1\mathrm{.}00)3\mathrm{.}50$

Material costs per set in Argentina $$20\mathrm{.}006\mathrm{.}00\%$ US inflation rate, per annum $1\mathrm{.}00\%$

Material and shipping costs of imports per set $$10\mathrm{.}000\mathrm{.}00\%$ Argentine inflation rate, per annum $5\mathrm{.}00\%$

Direct & indirect cost per set $$5\mathrm{.}000\mathrm{.}00\%$ Discount rate in United States $18\mathrm{.}00\%$

Depreciable investment $($buildings & equipment$)$ $$1,000,000$

Initial investment in net working capital $$1,000,000$

Discount rate in Argentina $20\mathrm{.}00\%$

The capital budgeting analysis needs to be performed on both the Project Level $($Project Viewpoint$)$ and the Parent Level $($Parent Viewpoint$).$