MSDI

Alcala de Henares, Spain

 Now Future
U.S. Dollar
NPV

Cash
Flows
Spanish Peseta
 Cash Flows
• Forecast foreign currency free cash flows
• Incorporate expected foreign currency inflation
• Use appropriate effective tax rate: generally the
higher of the foreign or domestic tax rates
• Include the terminal value: the market value of
disposal or the value of the perpetual cash flows
 Discount
• Method A: Discount at foreign WACC and
convert at spot rate
• Method B: Convert at expected spot rates
and discount at domestic WACC
 “Method A”
Now Future
U.S. Dollar
NPV

Cash
Flows
Spanish Peseta
 “Method B”
Now Future
U.S. Dollar
NPV

Cash
Flows
Spanish Peseta
 Recommend Method B
• Companies should know their domestic WACC but
may not know the foreign WACC
• Methods for forecasting spot rates are the same as
converting a domestic WACC to a foreign WACC
(forward parity, international Fisher effect,
purchasing power parity)
• Method B makes it much clearer what your
assumptions are (in the form of expected spot rates)
than Method A (in the form of a foreign WACC)
 Cash Flows
• Installed cost of new machinery
• Disposal of old machinery: net of market
value and tax effect of disposal
• After tax operating cost savings
• Tax effects of loss of old machinery
depreciation and gain of new machinery
depreciation
• No terminal cash flows
Installed Cost of New Machinery
• 61,525,000 ESP
 Disposal of Old Machinery
• 950,000 ESP Market Value
• 1,605,000 ESP Book Value
• 655,000 ESP (1,605,000-950,000) Loss on
Sale
• 229,250 ESP (655,000 x .35) Tax Benefit of
Sale
• 1,179,250 ESP (950,000+229,250) Net
Effect of Sale of Old Machinery
 After Tax Operating Cost
Savings
Year Old Cost New Cost Cost Saving After Tax

1988 88,496 69,676 18,820 12,233

1989 88,662 69,808 18,854 12,255
1990 93,686 73,763 19,923 12,950
1991 97,634 76,872 20,762 13,495
1992 101,091 79,594 21,497 13,973
1993 104,872 82,571 22,301 14,496
1994 109,101 85,901 23,200 15,080
1995 113,765 89,573 24,192 15,725
1996 119,012 93,704 25,308 16,450
1997 124,872 98,318 26,554 17,260
 Loss of Old Machinery
Depreciation
• 1,605,000 ESP Book Value
• 3 Years Remaining Straight Line
Depreciation
• 535,000 ESP (1,605,000/3) Depreciation
per Year
• 187,250 ESP (535,000 x .35) Depreciation
Tax Savings per Year
 Gain of New Machinery
Depreciation
• 61,525,000 ESP Book Value
• 10 Years Remaining Straight Line
Depreciation
• 6,152,500 ESP (61,525,000/10)
Depreciation per Year
• 2,153,375 ESP 6,152,500 x .35)
Depreciation Tax Savings per Year
 Net Cash Flows
Year Installed Cost Disposal Net Operating Old Machine New Machine Net
of New Machinery of Old Machinery Cost Savings Depreciation Depreciation Cash Flows

0 (61,525,000) 1,179,250 (60,345,750)

1 (1988) 12,233,000 (187,250) 2,153,375 14,199,125
2 (1989) 12,255,100 (187,250) 2,153,375 14,221,225
3 (1990) 12,949,950 (187,250) 2,153,375 14,916,075
4 (1991) 13,495,300 2,153,375 15,648,675
5 (1992) 13,973,050 2,153,375 16,126,425
6 (1993) 14,495,650 2,153,375 16,649,025
7 (1994) 15,080,000 2,153,375 17,233,375
8 (1995) 15,724,800 2,153,375 17,878,175
9 (1996) 16,450,200 2,153,375 18,603,575
10 (1997) 17,260,100 2,153,375 19,413,475
 Forward Rates
(Forward Parity)
• Spot Rate: 127.00 ESP/USD
• 1-Month Forward Rate: 125.85 ESP/USD
• 3-Month Forward Rate: 123.70 ESP/USD
• Expected Spot Rate Factor = .8961
((((123.70-127.00)/127.00) x 4) + 1)
 Interest Rates
(International Fisher Effect)
• Spanish Rates (Case): Short-Term Loans 18%;
Long-Term Loans 15%
• Spanish Rates (Exhibit 3): Daily Interbank Rate
18.1%; 6-12 Month Deposit Rate 8.8%; Short-Term
Commercial Loans 17.9%
• U.S. Rates (Case): Prime Loan Rate 8.5%
• U.S. Rates (Exhibit 4): 3 Month T-Bills 5.73%; 10
Year T-Bonds 8.34%; 6 Month Commercial Paper
6.85; Prime Commercial Rate 8.5%
• Expected Spot Rate Factor = 1.0599 (1.15/1.085)
 Inflation Rates
(Purchasing Power Parity)
• Spanish CPI: 8.8%
• U.S. CPI: 1.9%
• Expected Spanish Inflation: 8%?
• Expected U.S. Inflation: 4%?
• Expected Spot Rate Factor (Historical
Inflation) = 1.0677 (1.088/1.019)
• Expected Spot Rate Factor (Expected
Inflation) = 1.0385 (1.08/1.04)
 Other Information
• Economists’ 5-Year Forecasts: 80-170
ESP/USD
• Spanish Real GDP Growth: 3.3%
• U.S. Real GDP Growth: 2.9%
 Expected Spot Rates
Year Forward Rates Interest Rates Historical Expected Net
Inflation Rates Inflation Rates Cash Flows

Factor 0.8961 1.0599 1.0677 1.0385

0 127.00 127.00 127.00 127.00 (60,345,750)

1 (1988) 113.80 134.61 135.60 131.89 14,199,125
2 (1989) 101.98 142.67 144.78 136.97 14,221,225
3 (1990) 91.38 151.22 154.58 142.24 14,916,075
4 (1991) 81.89 160.27 165.04 147.72 15,648,675
5 (1992) 73.38 169.87 176.22 153.40 16,126,425
6 (1993) 65.76 180.05 188.15 159.31 16,649,025
7 (1994) 58.92 190.83 200.89 165.44 17,233,375
8 (1995) 52.80 202.27 214.49 171.81 17,878,175
9 (1996) 47.32 214.38 229.01 178.43 18,603,575
10 (1997) 42.40 227.22 244.51 185.30 19,413,475
 USD Cash Flows
Year Expected Net USD
Inflation Rates Cash Flows Cash Flows

0 127.00 (60,345,750) (475,163.39)

1 (1988) 131.89 14,199,125 107,659.25
2 (1989) 136.97 14,221,225 103,829.39
3 (1990) 142.24 14,916,075 104,865.19
4 (1991) 147.72 15,648,675 105,937.04
5 (1992) 153.40 16,126,425 105,124.00
6 (1993) 159.31 16,649,025 104,507.17
7 (1994) 165.44 17,233,375 104,164.83
8 (1995) 171.81 17,878,175 104,056.08
9 (1996) 178.43 18,603,575 104,263.95
10 (1997) 185.30 19,413,475 104,769.42
NPV = 95,317.59 USD
 Method A: ESP Discount Rate
• Forward Parity Discount Rate: 1.26% ((1.13 x .
8961)-1)
• International Fisher Effect Discount Rate: 19.77%
((1.13 x 1.0599)-1)
• Purchasing Power Parity Discount Rate (Historical
Inflation): 20.65% ((1.13 x 1.0677)-1)
• Purchasing Power Parity Discount Rate (Expected
Inflation): 17.35% ((1.13 x 1.0385)-1)
Method A: ESP NPV
Year Net
Cash Flows

0 (60,345,750)
1 (1988) 14,199,125
2 (1989) 14,221,225
3 (1990) 14,916,075
4 (1991) 15,648,675
5 (1992) 16,126,425
6 (1993) 16,649,025
7 (1994) 17,233,375
8 (1995) 17,878,175
9 (1996) 18,603,575
10 (1997) 19,413,475

Discount Rate 0.1735

NPV (ESP) 12,105,333.82

NPV (USD) 95,317.59

 Comparative NPVs

Theory Forward Rates Interest Rates Historical Expected

Inflation Rates Inflation Rates

NPV (ESP) 93,105,320.84 5,857,833.46 3,795,147.91 12,105,333.82

NPV (USD) 733,112.76 46,124.67 29,883.05 95,317.59