A financial manager has determined that the appropriate discount rate for a foreign project is 12 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 10 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 difference in nominal interest rates between two countries is proportional to the difference in their inflation rates, assuming that the real interest rates are equal across countries. The formula to adjust the discount rate is: $ (1 + i_{foreign}) = (1 + i_{domestic}) \times \frac{(1 + inflation_{foreign})}{(1 + inflation_{domestic})} $. Plugging in the given values: $ (1 + i_{foreign}) = (1 + 0.12) \times \frac{(1 + 0.10)}{(1 + 0.03)} $, solving this gives $ i_{foreign} \approx 0.19 $ or 19%.

A Financial Manager Has Determined That the Appropriate Discount Rate