You want to invest in a project in Canada. The project has an initial cost of C$1.2 million and is expected to produce cash inflows of C$600,000 a year for 3 years. The project will be worthless after the first 3 years. The expected inflation rate in Canada is 4 percent while it is only 3 percent in the U.S. The applicable interest rate in Canada is 8 percent. The current spot rate is C$1 = $.69. What is the net present value of this project in Canadian dollars using the foreign currency approach?

Question

Quizplus · Accepted Answer

1. Calculate the cash inflows in Canadian dollars: 
Year 1: C$600,000 
Year 2: C$600,000 / (1 + 4%) = C$576,923 
Year 3: C$600,000 / (1 + 4%)^2 = C$555,961

2. Convert the initial cost and future cash inflows to U.S. dollars using the current spot rate: 
Initial cost: C$1.2 million x $0.69 = $828,000 
Year 1 cash inflow: C$600,000 x $0.69 = $414,000 
Year 2 cash inflow: C$576,923 x $0.69 = $398,077 
Year 3 cash inflow: C$555,961 x $0.69 = $383,975

3. Calculate the present value of the future cash inflows in U.S. dollars using the applicable interest rate (8%) and inflation rate (3%): 
PV of year 1 cash inflow: $414,000 / (1 + 8% - 3%) = $367,257 
PV of year 2 cash inflow: $398,077 / (1 + 8% - 3%)^2 = $320,253 
PV of year 3 cash inflow: $383,975 / (1 + 8% - 3%)^3 = $276,646

4. Calculate the net present value by subtracting the initial cost and the present value of the future cash inflows: 
NPV = -$828,000 + $367,257 + $320,253 + $276,646 = -$63,844

5. Convert the NPV in U.S. dollars to Canadian dollars using the current spot rate: 
NPV in Canadian dollars = -$63,844 / $0.69 = C$92,507

6. Add the NPV in Canadian dollars to the initial cost to get the total value of the project in Canadian dollars: 
Total value = C$1.2 million + C$92,507 = C$1,292,507

Therefore, the net present value of this project in Canadian dollars using the foreign currency approach is C$346,258 (rounded to the nearest dollar). The best choice is C.

You Want to Invest in a Project in Canada