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]Assume the cost
Of capital for this project is 18.45% on pound investments. What is the NPV in pounds of this project
Using the foreign currency approach?

Question

Quizplus · Accepted Answer

1. Convert £16 million to Canadian dollars: £16 million x $1.20/£ = $19.2 million.
2. Calculate the cash inflows in Canadian dollars:
- Year 1: £7.6 million x $1.20/£ = $9.12 million
- Year 2: £7.6 million x $1.20/£ / (1 + 0.04) = $8.76 million
- Year 3: £7.6 million x $1.20/£ / (1 + 0.04)^2 = $8.42 million
3. Calculate the present value of the cash inflows using the cost of capital for pound investments:
- PV of Year 1 cash inflow: $9.12 million / (1 + 0.1845) = $7.72 million
- PV of Year 2 cash inflow: $8.76 million / (1 + 0.1845)^2 = $6.49 million
- PV of Year 3 cash inflow: $8.42 million / (1 + 0.1845)^3 = $5.42 million
4. Calculate the net present value in Canadian dollars:
- NPV = PV of cash inflows - initial cost
- NPV = $7.72 million + $6.49 million + $5.42 million - $19.2 million = -$0.58 million
5. Convert the NPV to pounds: -$0.58 million x £0.83/$ = -£0.48 million
6. The NPV is negative, so the firm should not purchase the subsidiary. Option B is the closest to the calculated NPV in pounds.

A Canadian ﬁRm Is Considering Purchasing a Subsidiary in Great