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Capital Budgeting with Exchange Risk

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Spartan Inc. (a US based MNC) is planning to open a subsidiary in Switzerland to manufacture shoes. The new plant will cost SF 1 billion. The salvage value of the plant at the end of the 4 yr economic life is estimated to be SF 200 million net of any tax effects. This plant will also call for extra inventory holding of SF 300 million, and extra accounts payables of SF 200 million. Projected sales from this new plant are SF 800 million per year. The fixed costs are estimated to be SF 300 million per year, and the variable costs are estimated to be SF 100 million per year. Depreciation on the new plant after accounting for the salvage value will be SF 200 million per year. The Swiss government will impose a 35 % tax on the earnings. US govt. will not impose any taxes. 100 % of the cash flows will be remitted to the parent. The exchange rate is expected to be stable at $ 0.80 per SF. Spartan requires 15 % return on its capital investments.

Please compute:

a) Net Investment Cost of the plant
b) Cash flows in years 1 through 4 of the project
c) Net Present Value of the project
d) Internal Rate of Return (IRR) of the project
e) Should the project be accepted or rejected? Why or why not?

f) If the exchange rate scenario unfolds as follows,

t=time 0 1 2 3 4

$0.80/SF $0.75/SF $0.70/SF $0.60/SF $0.550/SF

Re-compute the NP. Is the project still acceptable? Why or why not?

g) If the exchange rate scenario were to unfold as follows,

t=time 0 1 2 3 4

$0.80/SF $0.85/SF $0.90/SF $0.95/SF $1.00/SF

Re-compute the NP. Is the project still acceptable? Why or why not?

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The solution explains how to do capital budgeting given a change in exchange rates

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Spartan Inc. (a US based MNC) is planning to open a subsidiary in Switzerland to manufacture shoes. The new plant will cost SF 1 billion. The salvage value of the plant at the end of the 4 yr economic life is estimated to be SF 200 million net of any tax effects. This plant will also call for extra inventory holding of SF 300 million, and extra accounts payables of SF 200 million. Projected sales from this new plant are SF 800 million per year. The fixed costs are estimated to be SF 300 million per ...

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