Internal Financial Capital Budgeting Case Study

InternalFinancial Capital Budgeting: Case Study

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Internalfinancial capital budgeting: Case study

Solitairecase study

SolitaireMachinery is a Swiss multinational manufacturing company. Currently,Solitaire financial planners are considering undertaking a 1-yearproject in the United States. The project’s expecteddollar-denominated cash flows consist of an initial investment of$1,000 and a cash inflow in the following year of $1,200. Solitaireestimates that its risk-adjusted cost of capital is 12%. Currently, 1U.S dollar will buy 0.90 Swiss Francs. In addition, a 1 yearrisk-free securities in the United States are yielding 5% whilesimilar securities in Switzerland are yielding 3.25%.

Q1.If this project was instead undertaken by a similar U.S based companywith the same risk-adjusted cost of capital, what would be the netpresent value and rate of return generated by this project?

Giventhat the project was to be taken by a company based in the U.S, thefollowing is the calculation for the rate of return, and the netpresent value.

NPV= $1,000 + ($1,2000/1.14) = 52.63 Dollars

Rateof Return – $1,200/$1,000 – (1) = 20%.

Q.2What is the expected forward exchange rate 1 year from now?

Theinterest rate parity is used for this problem. The conditions thathold are as follows:-

ForwardExchange Rate/Spot Exchange Rate =

Therefore:-

ForwardExchange Rate/ 1.62 = 1.045/0.725

Hence:-

ForwardExchange rate = 1.5785 Swiss Francs per U.S Dollar.

Q3.IfSolitaire undertakes the project, what is the net present value andrate of return of the project for Solitaire?

Theapproach taken is first adjusting the cash flows to reflect thecompany’s home currency.

Year

CF in Dollars

CF in Swiss Francs

0

-1,000

-1.620

1

1,200

1,894.15

Thenext step is to calculate the Swiss Franc denominated cash flows.This helps find the appropriate NPV and rate of return for thecompany (Solitaire).

Therefore,

NPV= (-1,620) + (1,894.15 / 1.14) SF.

And,

Rateof Return = 1,894.15 / 1,620 – (1) = 16.92%.

of key learning points from the case

Oneof the main advantages of calculating NPV is that it demonstrates thesensitivity of discount rates (Brighton &amp Houston, 2015). If theNPV of a project is positive, then the project has to be carried on.A negative NVP results to cancellation of a project mainly becausethe cash flows may end up being negative, hence loss of revenue. Fromthe case, it has been observed that NPV computations are a summationof multiple discounted cash flows. These cash flows, be it negativeor positive, are converted into present value, in many cases when thecash flow begins. However, the situation is made complex when it isrealized that the investment may indeed not have the same risk asthough t through the entire time horizon. The function of theinternal rate of return is to make the net present value of all cashflows in capital budgeting (Bose, 2010). From the exercise, it hasbeen demonstrated that the higher the project’s internal rate ofreturn, the more favorable it is for the investors to adopt theproject. Given this, investors can use rate of return to assess aproject’s prospective and line them in terms of priority. If it isassumed that all factors ae equal among the projects, the investorswill be advised to take the project with the highest internal rate ofreturn. Therefore, another way of viewing rate of return is that itis the rate of growth that a certain project is most likely togenerate. Both NPV and IRR can therefore be used companies to makedecisions about the new investment or expansion of existinginvestments.

Appendix:Calculations

  1. Formula for NPV =

  1. Formula for rate of return =

ROI=(Gain from investment – cost of investment) / Cost of investment.

References

Bose,C. (2010). Fundamentalsof financial management (6thEd.). New Delhi, India: PHI Learning.

Brigham,E.F. &amp Houston, J.F. (2015). Fundamentalsof financial management (14thed.). Boston, MA: Cengage Learning.