To provide Groupo Ariel proper consultation on the purchase of recycling equipment, a future cash flow projection calculation when inflation of two countries is different and identified. Therefore the project must be calculated using the net present value of the program both in euros and pesos based on the assumption that purchasing power parity and uncovered interest parity remain constant. In my analysis I further analyze net present value when purchasing power parity does not remain constant.
The first step in analyzing Groupo Ariel’s options is to check out their cash flows. To calculate the net present value of Groupo Ariel’s Mexican subsidiary’s recycling equipment to get the incremental cash flow of the replacement of equipment. For 2008, beginning with revenue from sale of the old machine, tax is added from the sale since the actual sale price is lower than the book value of it, then the initial investment is subtracted which includes the purchase and installment cost. For the incremental cash flows from 2009 to 2018, the cost saving due to the replacement should be adjusted by the tax savings on depreciation. The tax savings on depreciation are found by subtracting the tax benefits of the old equipment that is being sold, and adding the tax benefits of the new equipment that is being bought. The cost savings is influenced by inflation, therefore cash flow changes when inflation fluctuates as well. Secondly are the exchange rates. The single exchange rate that can be used is the spot rate 15.99 in 2008. However it can also be converted from Pesos into Euro-dollars each period using forward exchange rates. When purchasing power parity and uncovered interest parity remain constant, the
forward exchange rate is calculated normally. But when the purchasing power parity and uncovered interest parity change, the forward rate is assumes that the exchange between MXN and EUR will increase from 15.99 to 20.00 by the time 2011 comes and up to 25.00 by 2018. Next, is the hurdle rate. The hurdle rate is basically the minimum rate of return on the project in regards to the same project in France. The hurdle rate in France is 8% for the same project. This must also be taken into consideration when calculating the exchange rates with the power parity holding and with it changing. Lastly is tax and inflation. Initially the cash flows are all in pesos therefore Mexico’s tax rate of 35% must be used. However, in terms of inflation, in Mexico the inflation rate is 7% and only 3% in France. By using the second scenario with RPPP and UIP changing, both countries find themselves with equal rates at 3%.
After computing the NPV in the first scenario with power parity and uncovered interest parity holding, the net present value is 1,478,998.83 pesos which translates to 92,495.24 Euro at the spot rate of 15.99. In the second scenario with the exchange rate being calculated as 1.04(1+7%/1+3%), the net present value is the same at 92,495.24 Euro. Next are the inflation rates. Again, when the power parity and uncovered interest parity hold the rates are both 3%. After you repeat the net present value calculation the new number for the equipment project is 869,716 pesos or 54391.24 Euros.
In the second scenario, with changes in purchasing power parity and uncovered interest parity, the inflation rate is still 3% in both France and Mexico. Frances new hurdle rate however is adjusted by the future exchange rate. Therefore from 2008-2011 it is 17.03%, 2011-2013 it is 20.00% and from 2013-2018, 8% because the cash flows are discounted at different rates. This way, by repeating the NPV calculation under the first scenario totals to 314909.29 pesos or 19,694.14 Euros. However under the second scenario we assume the MXN to EUR exchange rate increases from 15.99 to 20.00 and again to 25.00. Therefore you convert the cash flows at those rates and discount the cash flows by France’s 8% hurdle rate. This leaves a net present value of 335,479.38 pesos or 20,980.57 Euros. After seeing all these calculations it is clear that the numbers are different.
Calculating these present values takes two different approaches. They both take the rate of change and risk in foreign currency into different considerations. The second scenario takes the forecasted rates directly from the differences in inflation rates; whereas the first scenario took into consideration, the cost of capital using the same inflation differences. But now in the second scenario the net present values change because the changes in inflation can’t be influenced by the changes in the currencies. Therefore if the project foresees huge changes in currency then it is better to translate the figures into the domestic currency rather than where the project is being proposed. However, if the cost of capital is valued rationally the company should discount the cash flows with the foreign cost of capital. I believe Groupo Ariel should purchase the equipment because if the forecasted rates are correct the purchase seems very profitable.