Assume that Baps Corporation is considering the establishment of a subsidiary in Norway. The initial investment required by the parent is $5,000,000. If the project is undertaken, Baps would terminate the project after four years. Bapsâ?? cost of capital is 13%, and the project is of the same risk as Bapsâ?? existing projects. All cash flows generated from the project will be remitted to the parent at the end of each year. Listed below are the estimated cash flows the Norwegian subsidiary will generate over the projectâ??s lifetime in Norwegian kroner (NOK):
Year 1 Year 2 Year 3 NOK10,000,000 NOK15,000,000 NOK17,000,000 YEAR 4 NOK20,000,000
The current exchange rate of the Norwegian kroner is $.135. Bapsâ?? exchange rate forecast for the Norwegian kroner over the projectâ??s lifetime is listed below:
Year 1 Year 2 Year 3 Year 4
$.13 $.14 $.12 $.15
a. What is the net present value of the Norwegian project?
b. Baps is also uncertain regarding the cost of capital. Recently, Norway has been involved in some political turmoil. What is the net present value (NPV) of this project if a 16% cost of capital is used instead of 13%?
c. Assume that NOK8,000,000 of the cash flow in year 4 represents the salvage value (i.e. project generates only NOK12,000,000). Baps is not completely certain that the salvage value will be at current time (Year 0). Will the amount of salvage affect company investment decision (assuming cost of capital is 13%)? Why?
This solution assists in determining the cash flow and net present value.