A Canadian ﬁrm is considering purchasing a subsidiary in Great Britain. The subsidiary will cost £16 million and will generate cash inﬂows of £7.6 million per year at the end of each of the next three
Years. After that, the company will be worthless. The current exchange rate is £0.83 British pounds
Per $1. The Canadian inﬂation rate is expected to be 4% over this period. The current risk-free rate
Of interest in Canada is 5% and the risk-free rate in Great Britain is 8%.[LINE][LINE]What is the NPV
In dollars of this project using the home currency approach?

Question

Quizplus · Accepted Answer

1. First, we need to convert the cost of the subsidiary to Canadian dollars using the current exchange rate: 
£16 million x $0.83/£1 = $19.36 million. 
So, the cost of the subsidiary in Canadian dollars is $19.36 million.

2. Next, we need to calculate the present value (PV) of the cash inflows using the risk-free rate in each country: 
PV of year 1 cash inflow = £7.6 million / (1 + 8%) = £7.037 million. 
Convert to Canadian dollars: £7.037 million x $0.83/£1 = $8.344 million. 
PV of year 2 cash inflow = £7.6 million / (1 + 8%)^2 = £6.496 million. 
Convert to Canadian dollars: £6.496 million x $0.83/£1 = $7.056 million. 
PV of year 3 cash inflow = £7.6 million / (1 + 8%)^3 = £5.620 million. 
Convert to Canadian dollars: £5.620 million x $0.83/£1 = $6.646 million. 
So, the total PV of cash inflows is $22.046 million.

3. Calculate the NPV: 
NPV = PV of cash inflows - cost of subsidiary 
NPV = $22.046 million - $19.36 million = $2.686 million.

4. Adjust for inflation: 
We need to adjust the NPV for Canadian inflation over the next three years. One way to do this is to use the Canadian risk-free rate as the discount rate for the cash inflows. 
PV of year 1 cash inflow adjusted for inflation = £7.6 million / (1 + 5% + 4%) = £6.647 million. 
Convert to Canadian dollars: £6.647 million x $0.83/£1 = $7.123 million. 
PV of year 2 cash inflow adjusted for inflation = £7.6 million / (1 + 5% + 4%)^2 = £5.664 million. 
Convert to Canadian dollars: £5.664 million x $0.83/£1 = $6.858 million. 
PV of year 3 cash inflow adjusted for inflation = £7.6 million / (1 + 5% + 4%)^3 = £4.892 million. 
Convert to Canadian dollars: £4.892 million x $0.83/£1 = $6.094 million. 
Total PV of cash inflows adjusted for inflation = $20.075 million.

5. Recalculate the NPV adjusted for inflation: 
NPV (adjusted for inflation) = $20.075 million - $19.36 million = $715,000.

So, the NPV in Canadian dollars using the home currency approach is $489,269 ($2.686 million minus $715,000).

A Canadian ﬁRm Is Considering Purchasing a Subsidiary in Great