Financing and the Currency Swap Decision
Response to the following problem:
Bradenton Co. is considering a project in which it will export special contact lenses to Mexico. It expects that it will receive 1 million pesos after taxes at the end of each year for the next 4 years and after that time its business in Mexico will end as its special patent will be terminated. The peso's spot rate is presently $.20. The U.S. annual risk-free interest rate is 6 percent, while Mexico's annual risk-free interest rate is 11 percent. Interest rate parity exists. Bradenton Co. uses the 1-year forward rate as a predictor of the exchange rate in 1 year. Bradenton Co. also presumes the exchange rates in each of years 2 through 4 will also change by the same percentage as it predicts for year 1. Bradenton searches for a firm with which it can swap pesos for dollars over each of the next 4 years. Briggs Co. is an importer of Mexican products. It is willing to take the 1 million pesos per year from Bradenton Co. and will provide Bradenton Co. with dollars at an exchange rate of $.17 per peso. Ignore tax effects. Bradenton Co. has a capital structure of 60 percent debt and 40 percent equity. Its corporate tax rate is 30 percent. It borrows funds from a bank and pays 10 percent interest on its debt. It expects that the U.S. annual stock market return will be 18 percent per year. Its beta is .9.
Bradenton would use its cost of capital as the required return for this project.
a. Determine the NPV of this project if Bradenton engages in the currency swap.
b. Determine the NPV of this project if Bradenton does not hedge the future cash flows.