You are a successful U.K. wine producer and are considering investing in a second operation in the

Question:

You are a successful U.K. wine producer and are considering investing in a second operation in the country of Vino (with currency V). International parity conditions hold, and the investment will be 100 percent equity-financed. Interest and inflation rates and the characteristics of the investment project are as given in Exhibit T13.2.
a. What is the nominal required return on wine investments in the U.K.? in Vino?
b. Identify expected future cash flows on this foreign investment project. Discount these cash flows at the vino-unit from a) to find NPV0V. Use the current spot rate to transfer this value to NPV0£.
c. Translate Vino-unit cash flows to pounds at expected future spot rates and discount at the pound from a) to find NPV0£.. Is the answer the same as in b)?
Exhibit T13.2
Wine production in Vino
U.K.Vino
Nominal risk-free government T-bill rateiF£ = 7.1%iFV =12.2%
Real required return on T-billsqF£ = 2.0%qFV = 2.0%
Expected future inflationp£ = 5.0%pV = 10.0%
Real required return on wine productioni£ = 12.0%iV = 12.0%
Current spot = V10/£
The following information is known about the project:
• The project has a 3-year life. Assume all operating cash flows occur at year-end.
• An investment of V800, 000 will purchase the vineyard. Its real value will remain constant throughout the investment's life and the vineyard will be sold at the end of the project.
• The winery and wine presses will cost V425, 000. In addition, the wine press supplier has given price quotes of V47, 500 and V27, 500 for the machinery's installation and modification, respectively. All cash outlays are payable at the start of the project.
• Annual depreciation for winery and wine presses is 33%, 45%, 15%, and 7% over the four-year project. (This happens to be identical to 3-year ACRS in the United States.) The winery and presses are expected to have a total market value of V45, 000 in nominal terms at the end of the project's life in three years.
• No investment in net working capital is necessary. All of the business's transactions are conducted in cash, and just-in-time inventory control will be used.
• Annual sales revenues are expected to be V700, 000, V800, 000, V900, 000 in nominal terms over the next 3 years. Variable operating costs are 10% of sales. Fixed costs are V5, 000 each year in nominal terms.
• Income and capital gains taxes are 50% in each country. Discount Rate
Depending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal... Exchange Rate
The value of one currency for the purpose of conversion to another. Exchange Rate means on any day, for purposes of determining the Dollar Equivalent of any currency other than Dollars, the rate at which such currency may be exchanged into Dollars...