Tutorial Problem Set 7

Topic: Chapter 16:

Foreign Direct Investment &
Capital Budgeting
FM303: International Finance
Week 10, Sem. 1, 2019
Question 1: Two projects, A and B, give the following cash flows over a period of five years (capital
cost is incurred at year 0):
A: -150 40 50 60 70 90

B: -110 20 30 40 50 70

Assuming that the cost of capital is 8%, calculate the net present values of the two projects. If the
two projects are mutually exclusive, which one will be chosen?

Solution
40 50 90
NPV ( A)  150   2
    90.24
1.08 (1.08) (1.08) 5

20 30 70
NPV ( B)  110   2
    50.38
1.08 (1.08) (1.08) 5

Therefore, project A should be chosen.

Question 2: Assuming a tax rate of 20% and a total equity financing, calculate the net present values
of projects A and B described in the previous problem. If the two projects are mutually exclusive,
which one will be chosen?

Solution
The after-tax cash flows are as follows:

A: -150 32 40 48 56 72

B: -110 16 24 32 40 56

The NPVs are calculated as in the previous problem. The two projects have NPVs of 42.19 and
18.31, respectively. Project A should be selected.

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Question 3: Use the same information as in the previous two problems but assume now that the
two projects, A and B, have salvage values of 20 and 45, respectively. Calculate the net present
values of the two projects and determine which one will be chosen if they are mutually exclusive.

Solution
At year 5, project A will have an additional cash flow of 20, while project B will have an additional
cash flow of 45. Assuming that the cash flows arising from the salvage values are not taxed, A and
B will have NPVs of 55.80 and 48.93, respectively.

Question 4. Assume now that project A is financed by 70% equity and 30% debt while project B
of problem 1 is financed by 40% equity and 60% debt. If the cost of equity financing is 8% and the
cost of debt financing is 5%, calculate the net present values of the two projects, assuming the
same salvage values and tax rates as previously. Which project will be chosen if they are mutually
exclusive?

Solution
The cost of capital can be calculated from equation (16.4) as follows. The cost of capital for project
A is:

70 30
8   5  (1  0.2)  6.8%
100 100

The cost of capital for project B is:

40 60
8   5  (1  0.2)  5.6%
100 100

The NPVs of the two projects are therefore 63.69 and 55.72. Therefore, A should be selected.

Question 5. Assume that project A is a domestic project subject to a 20% tax rate, while project B
of problem 1 is a foreign project subject to a foreign tax rate of 15% for which full tax credit is
given. The cash flows and the salvage value of project B are expressed in foreign currency terms.
The current value of the exchange rate (domestic/ foreign) is 0.95, and the foreign currency is
expected to depreciate by 5% a year over the next five years. Calculate the net present values of
the two projects. Which project will be chosen if they are mutually exclusive?

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Solution
The cash flows arising from project B are the following:

Cash flow 0 1 2 3 4 5
Before foreign tax in foreign
-110 20 30 40 50 70
currency
After foreign tax in foreign
-110 17 25.5 34 42.5 59.5
currency
Exchange rate (5%
0.95 0.90 0.90 0.90 0.90 0.90
depreciation over 5 years)
After foreign tax in domestic
-104.5 15.3 23.0 30.7 38.4 53.7
currency
After foreign and domestic
taxes in domestic -104.5 14.6 21.9 29.2 36.4 51.0
currency(20%-15%)

NPV $11.47

The NPVs of projects A and B are 42.2 and 11.5, respectively. Project A should be selected.

Question 6. An FDI project that is run by a subsidiary produces the following cash flows over a
period of five years:

-200 20 70 90 110 150

The following information is also available:

Foreign tax rate 20%

Domestic tax rate (full tax credit is granted) 30%
Remitted cash flows allowed 75%
Current exchange rate (domestic/foreign) 0.80
Expected annual depreciation of foreign currency 4.5%
Discount rate 6.5%

Calculate the net present value of the project from the perspectives of the subsidiary and that of the
parent company.

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Solution
From the perspective of the foreign company, the project produces the following cash flows:

Cash flow 0 1 2 3 4 5
Before foreign tax in foreign currency -200 20 70 90 110 150
After foreign tax in foreign currency -200 16 56 72 88 120
Remitted amount -200 12 42 54 66 90
Exchange rate 0.80 0.76 0.73 0.70 0.67 0.64
Before tax in domestic currency -160 9.12 30.66 37.83 44.22 57.60
After tax in domestic currency -160 8.21 27.94 34.02 39.80 51.84

The NPV from the perspective of the subsidiary is 79.99. From the perspective of the parent company
it is –31.03.

Question 7: Consider project A from problem 1. Calculate the NPV of the project by using the
following discount rate values: 4, 5, 6, 7, 8, 9 and 10. Plot the NPV against the discount rate.

Solution
The following table shows how the NPV changes with the discount rate. The higher the discount
rate, the lower the NPV.

Discount rate NPV

4 99.48
5 97.10
6 94.77
7 92.48
8 90.23
9 88.03
10 85.87

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 102
100
98
96
94
92
90
88
86
84
3 4 5 6 7 8 9 10 11

Question 8. Assume that the values of the discount rate in problem 7 are associated with probabilities
of 0.05, 0.10, 0.15, 0.20, 0.25, 0.10 and 0.15, respectively. Calculate the expected NPV.
Solution
The expected value of the NPV is 91.64.

Question 9. Consider project B from problem 1 under three scenarios: (i) the cash flows are as given;
(ii) the cash flows are 20% higher; and (iii) the cash flows are 20% lower. Using a discount rate of
10%, calculate the NPV under these three scenarios. If these scenarios materialise with probabilities
of 0.1, 0.3 and 0.6, respectively, what is the expected NPV?

Solution
The NPV under the three scenarios is reported in the following table. The expected value of the
NPV is 71.72.
Scenario NPV Probability
i 85.87 0.10
ii 133.05 0.30
iii 38.70 0.60

~The End~

RRK/SI/2019/FM303/W10-11TUT