Capital Budgeting and Financing Cantoon Co. is considering the acquisition of a unit from the French government. Its initial outlay would be $4 million. Cantoon will reinvest all the earnings in the unit. It expects that at the end of eight years, it will sell the unit for 12 million euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free interest rate is 5 percent regardless of the maturity of the debt, and the annualized risk-free interest rate on euros is 7 percent, regardless of the maturity of the debt. Assume that interest rate parity exists. Cantoon’s cost of capital is 20 percent. It plans to use cash to make the acquisition. Determine the NPV under these conditions. Rather than use all cash, Cantoon could partially finance the acquisition. Specifically, it could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay a lump-sum total of 7 million euros at the end of eight years to repay the loan. There are no interest payments on this debt. This financing deal is structured such that none of the payment is tax deductible. Determine the NPV if Cantoon uses the forward rate instead of the spot rate to forecast the future spot rate of the euro and elects to partially finance the acquisition. You need to derive the eightyear forward rate for this question.

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 29QA
Textbook Problem

Capital Budgeting and Financing Cantoon Co. is considering the acquisition of a unit from the French government. Its initial outlay would be $4 million. Cantoon will reinvest all the earnings in the unit. It expects that at the end of eight years, it will sell the unit for 12 million euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free interest rate is 5 percent regardless of the maturity of the debt, and the annualized risk-free interest rate on euros is 7 percent, regardless of the maturity of the debt. Assume that interest rate parity exists. Cantoon’s cost of capital is 20 percent. It plans to use cash to make the acquisition.

  1. Determine the NPV under these conditions.
  2. Rather than use all cash, Cantoon could partially finance the acquisition. Specifically, it could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay a lump-sum total of 7 million euros at the end of eight years to repay the loan. There are no interest payments on this debt. This financing deal is structured such that none of the payment is tax deductible. Determine the NPV if Cantoon uses the forward rate instead of the spot rate to forecast the future spot rate of the euro and elects to partially finance the acquisition. You need to derive the eightyear forward rate for this question.

This textbook solution is under construction.

Expert Solution

Want to see the full answer?

Check out a sample textbook solution.

Want to see this answer and more?

Experts are waiting 24/7 to provide step-by-step solutions in as fast as 30 minutes!*

*Response times vary by subject and question complexity. Median response time is 34 minutes and may be longer for new subjects.