An Indian company is investing in a 2-year project in Europe (EURO). Initial Investment = €4,000,000 Annual after-tax operating cash flow =…

(i) Working Notes: Applicable Forward Rates as per IRP USD/INR EUR/USD EUR/INR Spot INR 75 USD 1.20 INR 75 x USD 1.20 = INR 90 Year 1 Forward Rate INR 75 x (1.09)/(1.03) = INR 79.37 USD 1.20 x (1.03)/(1.05) = USD 1.177 INR 79.37 x USD 1.177 = INR 93.42 Year 2 Forward Rate INR 75 x (1.09)²/(1.03)² = INR 83.99 USD 1.20 x (1.03)²/(1.05)² = USD 1.155 INR 83.99 x USD 1.155 = INR 97.01 Step 1: Compare borrowing options: Option A: Borrow in INR @ 9% pre-tax so post tax effective rate = 9 x 0.7 = 6.3% Option B: Borrow in EUR @ 5% pre-tax so post tax effective rate = 5 x 0.7 = 3.5% Option C: Borrow in USD @ 3%. Here we need to apply IRP between EUR and USD. So, as per IRP: F = 1.20 x 1.03/1.05 =1.177, i.e. EUR is expected to depreciate. If you borrow in USD, effective EUR Cost = 1.03 x 1.05/1.03 = 1.05 = 5% Post Tax USD effective rate becomes 3.5% which is equal to EUR rate. Lower interest currency appreciates and wipes out or neutralizes interest advantage in USA, so there is no real advantage if borrowed from USA. Therefore, Option B Borrow in EUR is the best option. Step 2: Compute unlevered NPV Initial Investment in INR = 4 million x 90 = 360 million Discount rate = Unlevered cost of capital = 12% Year 1 = EUR 2.50 Million x 93.42 x 0.893 = 208.5601 million Year 2 = EUR 2.50 Million x 97.01 x 0.797 = 193.2924 million Total PV = 401.8525 million Unlevered NPV = 401.8525 million - 360 million = 41.8525 Million Step 3: Computation of PV of Tax Shield on Interest PV of Tax Shield for 2 years discounted @ before tax cost of debt i.e. @ 5%: = (30,000 x 0.952 x 93.42) + (30,000 x 0.907 x 97.01) = 5.3077 million Final APV: = 41.8525 million + 5.3077 million = 47.1602 million. Alternative Answer (i) Working Note: Applicable Forward Rates as per IRP USD/INR EUR/USD EUR/INR Spot INR 75 USD 1.20 INR 75 x USD 1.20 = INR 90 Year 1 Forward Rate INR 75 x (1.09)/(1.03) = INR 79.37 USD 1.20 x (1.03)/(1.05) = USD 1.177 INR 79.37 x USD 1.177 = INR 93.42 Year 2 Forward Rate INR 75 x (1.09)²/(1.03)² = INR 83.99 USD 1.20 x (1.03)²/(1.05)² = USD 1.155 INR 83.99 x USD 1.155 = INR 97.01 Option A (Borrowing in INR) Initial Investment EUR 40,00,000 x INR 90 INR 36,00,00,000 Debt Required INR 18,00,00,000 Interest Cost for 2 Years INR 18,00,00,000 x 9% x 2 (A) INR 3,24,00,000 Repayment of Debt (B) INR 18,00,00,000 Total Outflow INR 21,24,00,000 Option B (Borrowing in EUR) Initial Investment EUR 40,00,000 x INR 90 INR 36,00,00,000 Debt Required EUR 20,00,000 Interest Cost for Year 1 & 2 EUR 20,00,000 x 5% EUR 1,00,000 Applicable Forward Rate for Year 1 INR 93.42 Interest Payment for Year 1 (A) INR 93,42,000 Applicable Forward Rate for Year 2 INR 97.01 Interest Payment for Year 2 (B) INR 97,01,000 Repayment of Debt EUR 20,00,000 Applicable Forward Rate for Year 2 INR 97.01 Repayment of Debt in INR (C) INR 19,40,20,000 Total Outflow in INR INR 21,30,63,000 Option C (Borrowing in USD) Initial Investment EUR 40,00,000 x INR 90 INR 36,00,00,000 Debt Required EUR 20,00,000 Spot Rate of EUR/USD USD 1.20 USD 24,00,000 Interest Cost for Year 1 & 2 USD 24,00,000 x 3% USD 72,000 Applicable Forward Rate for Year 1 INR 79.37 Interest Payment for Year 1 INR 57,14,640 Applicable Forward Rate for Year 2 INR 83.99 Interest Payment for Year 2 INR 60,47,280 Repayment of Debt USD 24,00,000 Applicable Forward Rate for Year 2 INR 83.99 Repayment of Debt in INR (C) INR 20,15,76,000 Total Outflow in INR 21,33,37,920 Since cash outflow is least in case of borrowing in INR same option should be opted for. (ii) Computation of Adjusted Present Value under the cheapest option First, we shall compute the base NPV of the Project as follows: Year Cash Flow EUR Applicable Rate Amount in INR PVF PV 0 -40,00,000 90 -36,00,00,000 1 -36,00,00,000 1 25,00,000 93.42 23,35,50,000 0.893 20,85,60,150 2 25,00,000 97.01 24,25,25,000 0.797 19,32,92,425 NPV 4,18,52,575 Now we shall calculate PV of side effect of Financing in INR. Year Interest Tax Shield PVF @9% PV in INR 1 1,62,00,000 48,60,000 0.917 44,56,620 2 1,62,00,000 48,60,000 0.842 40,92,120 85,48,740 Thus, the Adjusted Present Value of the Project Using the Forward Rate base NPV: = Base NPV + PV of Tax Shield of Financing = INR 41,852,575 + INR 85,48,740 = INR 5,04,01,315