A financial manager has determined that the appropriate discount rate for a foreign project is 15 percent. However, that discount rate applies in the United States using dollars. What discount rate should be used in the foreign country using the foreign currency? The inflation rates in the United States and in the foreign country are expected to be 5 percent and 7 percent, respectively.

Question

Quizplus · Accepted Answer

The correct discount rate in the foreign country can be calculated using the International Fisher Effect, which suggests that the real interest rate is constant across countries. According to this principle, the nominal interest rate in a country (i) is approximately equal to the real interest rate (r) plus the expected inflation rate (π) in that country, i.e., i ≈ r + π. The formula to adjust the discount rate from one country to another considering inflation rates is: $i_f = \frac{(1 + i_h)(1 + π_f)}{(1 + π_h)} - 1$, where $i_f$ is the foreign nominal interest rate, $i_h$ is the home nominal interest rate, $π_f$ is the foreign inflation rate, and $π_h$ is the home inflation rate. Substituting the given values: $i_f = \frac{(1 + 0.15)(1 + 0.07)}{(1 + 0.05)} - 1 = 0.17$ or 17%.

A Financial Manager Has Determined That the Appropriate Discount Rate