Crum Industries is a paper manufacturing company based in the United States. The CEO of the company Hannah Monstzka is considering an investment in Canada to take advantage of Canadian government subsidies. The investment will have the following cash flows: Initial cost = C$-2,000,000, Year 1 = C$1,250,000, Year 2 = C$1,000,000, Year 3 = C$750,000. Monstzka plans on hedging the cash flows using forward contracts throughout the life of the project. The risk-free rate of interest in Canada is 5% and the risk-free rate of interest in the U.S. is 4%. Currently the spot rate is $0.7134/C$ and the project should be discounted at a U.S. adjusted rate of 9%. Assume Monstzka will be able to convert the Canadian dollar cash flows into U.S. dollars at the implied forward rates when they are received. What is the NPV of the project in U.S. dollars?

Question

Quizplus · Accepted Answer

To calculate this problem you need to first calculate the implied forward rates from the information given. You do this by using the interest rate parity formula. The one year forward rate is calculated by using the following formula: (1-year forward / $0.7134/C$) = (1.04)^1 / (1.05)^1. This gives you a 1-year forward rate of $0.7066/C$. You would use interest rate parity to calculate the two and three year forward rates as well. They are $0.6999/C$ and $0.6932/C$, respectively. Next you need to multiply the Canadian dollar cash flows by the appropriate forward rate and discount them back using the appropriate discount rate of 9%. The converted U.S. dollar cash flows that you need to discount are: Initial cost = $1,426,800 Year 1 = $883,250, Year 2 = $699,900, Year 3 = $519,900. When you discount these cash flows at 9% you will get a NPV of $374,071.

Crum Industries Is a Paper Manufacturing Company Based in the United