Capital Budgeting Analysis Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. Although the company is generally risk averse, it is attracted to the project because of a government guarantee. The project will generate a guaranteed NZS8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is 5 percent, whereas the nominal one-year interest rate in the United States is 9 percent. Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect (IFE). He also believes that interest rate parity holds. He provides this information to three recent finance graduates whom he just hired as managers and asks them for their input. The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a for ward contract or are not hedged. Is this manager correct? Explain. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain. The third manager states that the project should be hedged because the forward rate contains a premium and, therefore, the forward rate will generate more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain.

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 14, Problem 25QA
Textbook Problem

Capital Budgeting Analysis Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. Although the company is generally risk averse, it is attracted to the project because of a government guarantee. The project will generate a guaranteed NZS8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is 5 percent, whereas the nominal one-year interest rate in the United States is 9 percent. Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect (IFE). He also believes that interest rate parity holds. He provides this information to three recent finance graduates whom he just hired as managers and asks them for their input.

  1. The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a for ward contract or are not hedged. Is this manager correct? Explain.
  2. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
  3. The third manager states that the project should be hedged because the forward rate contains a premium and, therefore, the forward rate will generate more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain.

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