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**Exhibit 1**

Wine production in Vino

U.K. Vino

Nominal risk-free government T-bill rate iF£ = 7.1% iFV =12.2%

Real required return on T-bills qF£ = 2.0% qFV = 2.0%

Expected future inflation p£ = 5.0% pV = 10.0%

Real required return on wine production i£ = 12.0% iV = 12.0%

Current spot exchange rate S0£/V = V10/£

The following information is known about the project

• The project has a 3-year life. Assume all operating cash flows occur at year-end.

• An investment of V800,000 will purchase the vineyard. Its real value will remain constant throughout the investment’s life and the vineyard will be sold at the end of the project.

• The winery and wine presses will cost V425,000. In addition, the wine press supplier has given price quotes of V47,500 and V27,500 for the machinery’s installation and modification, respectively. All cash outlays are payable at the start of the project.

• Annual depreciation for winery and wine presses is 33%, 45%, 15%, and 7% over the next four years. The winery and presses are expected to have a total market value of V45,000 in nominal terms at the end of the project’s life in three years.

• No investment in net working capital is necessary. All of the business’s transactions are conducted in cash, and just-in-time inventory control will be used.

• Annual sales revenues are expected to be V700,000, V800,000, V900,000 in nominal terms over the next 3 years. Variable operating costs are 10% of sales. Fixed costs are V5,000 each year in nominal terms.

• Income and capital gains taxes are 50% in each country.

The calculation of the depreciation is provided below. The depreciation schedule is identical to the Modified Acceleration Cost Recovery System (MACRS) is the US tax code. Under MACRS, assets that have 3-year life are depreciated over 4 years. In this question, depreciation schedule is calculated for you as follows

Depreciation tax shield calculation: (Depreciable base = V500,000)

Beginning Depr Depr Ending Tax

Year balance % expense balance shield

1 V500,000 33% V165,000 V335,000 V82,500

2 V335,000 45% V225,000 V110,000 V112,500

3 V110,000 15% V75,000 V35,000 V37,500

4 V35,000 7% V35,000 V0 V17,500

Thus, in calculating NPV, the CF associated with depreciation for t=1,2,3 are V82,500, V112,500, V37,5000 respectively. At the end of year 3, the assets have a remaining book value of V35,000. This remaining book value will affect dis-investment CF at the end of the project.

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1. You are a successful U.K. wine producer and are considering investing in a second operation in the country of Vino (with currency V). International parity conditions hold, and the investment will be 100 percent equity-financed. Interest and inflation rates and the characteristics of the investment project are as given in Exhibit 1. (Answers are provided below)

a. What is the nominal required return on wine investments in the U.K.? in Vino? (4 pts)

b. Identify expected future cash flows on this foreign investment project. Discount these cash flows at the vino-unit discount rate from a) to find NPV0V. Use the current spot rate to transfer this value to NPV0£. (12 pts)

c. Translate vino-unit cash flows to pounds at expected future spot rates and discount at the pound discount rate from a) to find NPV0£.. Is the answer the same as in b)? (8 pts)

ANSWER:

a. (1+iN£) = (1+real proj rate£)(1+inflation£) iN£ = (1.12)(1.05) – 1 = 0.176 or 17.6%

(1+iNV) = (1+real proj rateV)(1+inflationV) iNV = (1.12)(1.10) – 1 = 0.232 or 23.2%

b. (see spreadsheet)

Initial Outlay = (V800,000) + (V425,000) + (V47,500) + (V27,500) = (V1,300,000)

Depreciation tax shield calculation: (Depreciable base = V500,000)

Beginning Depr Depr Ending Tax

Year balance % expense balance shield

1 V500,000 33% V165,000 V335,000 V82,500

2 V335,000 45% V225,000 V110,000 V112,500

3 V110,000 15% V75,000 V35,000 V37,500

4 V35,000 7% V35,000 V0 V17,500

After-tax operating cash flows:

CF1 = (V700,000 – V70,000 – V5,000)(1–0.5) + V82,500 = V395,000

CF2 = (V800,000 – V80,000 – V5,000)(1–0.5) + V112,500 = V470,000

CF3 = (V900,000 – V90,000 – V5,000)(1–0.5) + V37,500 = V440,000

Terminal Cash Flow = V800,000*(1.10)3 – {[ V800,000*(1.10)3 – V800,000]*0.5}

+ V45,000 – [(V45,000 –V35,000)*0.5] = V972,400

NPVV = V85,581 at iNV = 23.2%

NPV£ = V85,581/(V10/£) = £8,558.1 at V10/£

c. E(S1 £/V) = V10/£ (1.122/1.071) = V10.47619/£

E(S2 £/V) = V10/£ (1.122/1.071)2 = V10.97506/£

E(S3 £/V) = V10/£ (1.122/1.071) 3 = V11.49768/£

NPV£ = £8,558.1 at iN£ = 17.6%

This is the same as in b) because the international parity conditions hold.

2. Consider the Vino project described in Exhibit 1. Suppose the international parity conditions do not hold. In particular, assume real interest rates q£ = 0.0% and qV = 12.0%, and inflation p£ = 17.6% and pV = 10.0%, so that nominal interest rates are i£ = 17.6% and iV = 23.2% from the Fisher equation. Real project rates are same as in question 1. In addition, the expected spot rate is assumed to hold its nominal value such that E[StV/£] = £0.10/V in years 1 through 3. Current spot rate is same as before, S0£/V = V10/£. Calculate NPV£ using Methods #1 and #2 from the class notes. Should you invest in the project? How do you respond to this market disequilibrium? (24 pts)

Answer: First calculate the new project discount rates:

iN£ = nominal project rate in pounds

iNV = nominal project rate in vinos

(1+iN£) = (1+real proj rate£)(1+inflation£) iN£ = (1.12)(1.176) – 1 = 0.31712 or 31.712%

(1+iNV) = (1+real proj rateV)(1+inflationV) iNV = (1.12)(1.10) – 1 = 0.232 or 23.2%

Then follow the calculation template in question 1.

3. Consider the Vino project described in Exhibit 1. Suppose the international parity conditions do not hold with real interest rates of q£ = 12.0% and qV = 0.0%, and inflation of p£ = 5.0% and pV = 23.2%, so that nominal interest rates are i£ = 17.6% and iV = 23.2%. Real project rates are same as in question 1. The expected spot rate is expected to remain at E[StV/£ ] = £0.08/V in years 1 through 3. Current spot rate is same as before, S0£/V = V10/£. Calculate NPV£ using Methods #1 and #2 from the class notes. Should you invest in the project? How do you respond to this market disequilibrium? (24 pts)

Answer: First calculate the new project discount rates:

iN£ = nominal project rate in pounds

iNV = nominal project rate in vinos

(1+iN£) = (1+real proj rate£)(1+inflation£) iN£ = ?

(1+iNV) = (1+real proj rateV)(1+inflationV) iNV = ?

Then follow the calculation template in question 1.

4. Consider the Vino project described in Exhibit 1. Suppose the government of Vino requires that you operate a local crisis center for alcoholics. Your refusal to do so will result in a government veto of your investment project. Although the crisis center is expected to generate positive cash flow, you are not sure if it will be sufficient to compensate you for your initial investment and the opportunity cost of capital. The estimated cash flows associated with the crisis center are as follows:

Assume the appropriate vino-unit discount rate for the crisis center is iBV = 28% and answer the following questions

a. What name do we attach to this type of scenario? (4 pts)

b. Calculate NPV0V for the Vino project without and then with this side effect. Should you accept the project described in Exhibit 1 if you must accept the crisis center project? (20 pts)

5. Consider the Vino project described in Exhibit 1. Suppose the government of Vino offers you a three-year, subsidized, non-amortizing V500,000 loan if (and only if) you undertake the wine production investment. Assume they offer you an attractive loan rate of 12.2% even though corporate debt on similar investments yields 15% in vino-unit currency.

a. What is the effect of this offer on the vino-unit NPV of the project? (20 pts)

b. Suppose that the Vino government offers you the same loan regardless of whether you invest in the wine production project. What course of action would you take? (4 pts)

6. Consider the Vino project described in Exhibit 1. Suppose that beginning in year 2, there is a 20% chance each year the government will seize your assets in Vino. Specifically, if the assets are not seized, you expect to receive the cash flows described in Exhibit 1. However, if they are seized, you expect to receive only the repatriated funds from the previous year and none thereafter. What effect does this expropriation risk have on NPV0£? (24 pts)

7. Consider the Vino project described in Exhibit 1. Suppose 70% of your cash flow must be retained in Vino until the investment is 3 years old. Blocked funds are stored with the aging wine for luck and earn no interest. Assume the discount rate that appropriately reflects the riskiness of the blocked funds is iV = 15%. The corporate income tax rate is 40%. Funds that are not blocked can be repatriated at the end of the year in which they are earned.

a. What is the opportunity cost of the blocked funds? What is the value of the project with these blocked funds? (20 pts)

b. What is the advantage of separating the value of the project into two separate parts (that is, Vproject w/ blocked funds = Vproject w/ out blocked funds + Vblocked funds )? (4 pts)

8. The answers to the mid-terms are posted on Canvas. Study them and write down the question # you need extra explanation, if any. (e.g. # 2, 4, 6, 8 etc.) We will go through them next class. The same questions might appear in the final exam!

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