Determining NPV and 8 year forward rate.
Capital Budgeting and Financing.
Case Situation:
Cantoon Co. is considering the acquisition of a unit for the French government. Its intial outlay would be $4 million. It will reinvest all the earnings in the unit. It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free interest rate is 5 percent regardless of the maturity of the debt, and the annualized risk-free interest rate on euros is 7 percent, regardless of the maturity of the debt. Assume that interest rate parity exists. Cantoon's cost of capital is 20 percent. It plans to use cash to make the acquisition.
1) Determine the NPV under these conditions.
2) Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay a lump-sum total of 7 million euros at the end of 8 years to repay the loan. There are not interest payments on the debt. The way in which this financing deal is structured, none of the payment is tax deductible. Determine the NPV if Cantoon uses the forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to partially finance the acquisition. You need to derive the 8 year forward rate for this.