INTERNATIONAL FINANCE ASSIGNMENT

Question

Because of a recent ban on the import of U.S. made tennis rackets to Germany (in retaliation for anticipated restrictions on the import of German-made goods to the U.S.), a U.S. sporting goods manufacturer expects to create a German subsidiary to manufacture and distribute tennis rackets in Germany.

The project life is expected to be two years (at which time, an end to protectionist sentiment in the U.S. will lead to an end to trade restrictions). The required investment in the project is

a. DM 25,000,000 in plant and equipment, b. DM 5,000,000 in working capital.

The projected after-tax cash flows from the project are DM 20,000,000 for the next two years, in addition to DM5,000,000 from the liquidation of working capital in two years. The spot exchange rate (S$/DM) is $0.6500/DM1 . The interest rate in the U.S. (RUS ) is 6 percent per year while the German interest rate (RDM ) 11 percent per year.

Assuming that the firm has a WACC of 12%, showing all calculations indicate whether the project should be accepted.

Solution

Predicted Exchange Rates

If the real rate of interest is the same in all countries (due to the international mobility of capital) the International Fisher Effect implies that differences in nominal interest rates will signal differences in the expected rates of inflation across countries. Given that RUS is 6 percent per year and that the German interest rate RDM is 11 percent per year, we would expect the expected rate of inflation in Germany to be roughly 5 percent greater than the expected rate of inflation in the US.
Relative Purchasing Power Parity implies that the expected changes in exchange rates should reflect differences the expected rates of inflation in the two countries in question,

= [ ]N

where E( S$/DM(t+n) ) denotes the exchange rate