A financial manager has determined that the appropriate discount rate for a foreign project is 17 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 3 percent and 8 percent, respectively.

Question

Quizplus · Accepted Answer

The correct discount rate in the foreign currency can be calculated using the International Fisher Effect, which suggests that the difference in nominal interest rates between two countries is proportional to the difference in their expected inflation rates. The formula to adjust the discount rate from one currency to another is: $1 + i_{foreign} = (1 + i_{domestic}) \times \frac{1 + inflation_{foreign}}{1 + inflation_{domestic}}$, where $i_{foreign}$ is the foreign interest rate, $i_{domestic}$ is the domestic interest rate, $inflation_{foreign}$ is the inflation rate in the foreign country, and $inflation_{domestic}$ is the inflation rate in the domestic country.Given:- $i_{domestic} = 17\% = 0.17$- $inflation_{domestic} = 3\% = 0.03$- $inflation_{foreign} = 8\% = 0.08$Plugging these values into the formula:$1 + i_{foreign} = (1 + 0.17) \times \frac{1 + 0.08}{1 + 0.03}$$1 + i_{foreign} = 1.17 \times \frac{1.08}{1.03}$$1 + i_{foreign} = 1.17 \times 1.04854$$1 + i_{foreign} \approx 1.22679$$i_{foreign} \approx 0.22679$Converting back to a percentage, $i_{foreign} \approx 22.68\%$, which rounds to 22 percent.

A Financial Manager Has Determined That the Appropriate Discount Rate