Calculating NPV by discounting in pesos and converting to dollars

1. Assume Merck is using 8% as their estimate of peseta inflation and 4% as the estimate for U.S. inflation for purposes of estimating cash flows, expected future spot rates, and the foreign cost of capital. Conduct an NPV analysis of this project by discounting in pesos and converting the peso NPV to dollars at today’s spot rate. Next, convert the peso cash flows into dollars at expected future spot rates and then discount in dollars. Are the NPVs the same? Why?

2. Suppose the inflation rate is expected to be 4% in each currency. Inflate the cost projections in Exhibit 2 at these rates and repeat the valuation in 1. How much is the increase in value under the two approaches? Where does it come from?

3. Consider the last paragraph of the case (before the exhibits). Instead of the peseta appreciating against the dollar as someexperts think, suppose a different currency expert thinks the peseta is going to lose value against the dollar due to a crisis associated with upcoming Spanish elections. In particular, he believes the peseta will fall from its current value of Pts127/$ to Pts150/$ next year, Pts170/$ in the second year, and will then remain at Pts170/$ indefinitely. This represents a possible (andserious for Merck) deviation from UIP. Repeat the valuation in 1a and 1b. What do you find?

Considering the NPV calculation that has been performed in the excel sheet, it can be stated that the process is dedicated to present only the present value of an uneven cash flow. Despite the involvement of the term “net”, the factor only suggests the present value by considering the cash flow function. It has always been the way for this particular function and leads the organization to be able to cope with the present scenario by the reflected future scenario. Therefore, it can be understood that net present value is defined to be an establishment of the present value of the expected future cash flows from making the deduction of the initial investment made by the company (Gibbons 2015). Also, it can be understood that ‘Net’ refers to some significant factors that have been reduced from the gross result.

Considering this particular case, the calculation of NPV has been done in the spreadsheet with the use of NPV function while leaving the initial outlay. In the case of the initial outlay, the reflected result is portrayed in the negative form. Due to that, IO is needed to be subtracted with the generated result, and it has been performed within the spreadsheet outside of the NPV function. Here, based on the provided scenario, the peseta inflation level is 8%, and 4% is estimated to be the US level of inflation. With the NPV calculation performed within the spreadsheet, the difference regarding the discounting in pesos and converting the peso NPV to dollars can be observed. The process is contributed by converting the peso cash flows into dollars at expected future spot rates as well as discounting them into dollars (Helbæk, Lindest and McLellan 2010). One of the major understandings can be raised out of the calculations that both of the factors are not same regarding their results and proper causes behinds scenario have also been acknowledged.

Differences between NPVs obtained from discounting in pesos and dollars

One of the major reasons is the difference regarding the discount rate, which can be reflected by the associated inflation rates. Here, according to the scenario, the peseta inflation rate is 8%, and the US is 4%. On the other hand, it should need to remember that the calculation and result of present value are highly influenced by the discounted rates, which help to discount the future amount to the present. This is the major cause leading to the different value in the excel spreadsheet.

Additionally, it is needed to mention that the calculation of NPV is based on considering the present value of cash inflows and deducting the present value of cash outflows (Moles 2011). With the application of the discounted rate, this present values of both cash inflows and outflows will be changed from each other and will impact the highlighted result in the spreadsheet. The same scenario has been observed in this particular case also.

The scenario, where the inflation rate has been treated as 4% each, the result of the valuation also suggest the dissimilarity regarding the calculated value. Related to the decrease in the discounted rate caused by the reduction in the inflation rate, the increase in value regarding the established result can be found out of the calculation. Here, the particular cause of this certain occurrence must need to be judged effectively. While conducting the calculation by focusing the assumed rate of inflation, it can be proposed that the unevenness of the cash flows is the basic reason leading to the increase of value as well as the dissimilarity in the result (Perfluoroalkyl and -aryl Zinc Ate Complexes in Synthesis, 2015). It is also a major fact that there is no limit in terms of the number of cash flows utilised in the functional process, and this particular fact is applicable for all intents. Furthermore, it is needed to propose that the calculations presented and constructed in excel provide some number of facilities to the overall process. For an example, excel provides the ‘what if’ analysis which helped significantly during the changes in discounted rate. By the help of the process, many kinds of errors can also be avoided while the present value of the uneven trends of the cash flow can also be determined. Also, another identification has been made related to the contiguous arrangement of the cash flow as these are aligned separately in the spreadsheet.

Effect of inflation rate on valuation

Based on the calculation, it is understood that the future value of the newly identified equipment of the company is determined by the help of the calculation with considering the differently generated cash flows instead of the present values (Rahman 2015). As the inflation rates of both the variables are modified to remain these values same, the principal of value additivity has been utilised to perform the calculations. It refers to the identification of the future cash value of each cash flows in the individual manner and adding them together afterward. Therefore, the cumulative cash flow of the particular investment can be derived in the process of calculation, and this cumulative value continuously increases to generate a more increasing result than the previous scenario.

Firstly, the effective deduction from the hypothesis of uncovered interest parity (UIP) should need to be clarified which suggests the expected rate of return of two different countries related to the identical assets; the quality can be observed despite the involvement of the exchange rate growth. Here, the application of UIP can largely be observed in the industrialised countries, as these particular countries have widely tasted the process. Therefore, the involvement of UIP is a fundamental idea of the process of calculation, while it is required to mention that the process is widely debated among the different scholars and researchers (Real estate investment decision making – a review 2012). In this case, the particular importance has been provided by the deviations from the UIP, which facilitates the organizations to avail the unexploited profit opportunities. The Same particular scenario can be observed in the provided case as well. In this case, the major statement should need to develop that such an outcome or explanation should not be appreciated. Nonetheless, the deviations from the UIP are often presumed in a manner that these are often generated from the differences in the risks between two countries or the capital mobility of the countries. Sometimes, both of the factors are responsible on a combined basis to lead towards such aspect.

Here, in this particular calculation conducted in the spreadsheet, the sum of two elements from the UIP deviations are applied, namely the real interest differences between the two countries and the available growth factor in the bilateral exchange rate of the countries. Based on the performed analysis contributed the valuation, different types of decompositions can be found out. These decompositions assist in providing the suitable explanation to the nature of UIP deviations. Furthermore, some other signification understandings can also be secured out of the process; the particular scenario reflects the existence of the risk premiums during the changes in the real exchange rate considered to be zero or referred to be unpredictable and the free movement of the capital due to the real interest (Wo 2012). Additionally, it is essential to mention that the calculated results are relatively less in terms of their differences, as the countries in this scenario may be among the industrialised countries. The particular situation can be confirmed by looking at both the level of variance related to the real interest differential trend with regards to the growth in the real exchange rate.

References

Gibbons, A. (2015). How modern humans ate their way to world dominance. Science.

Helbæk, M., Lindest, S. and McLellan, B. (2010). Corporate finance. New York: McGraw-Hill.

Moles, P. (2011). Corporate finance. Hoboken, N.J.: Wiley.

Perfluoroalkyl and -aryl Zinc Ate Complexes in Synthesis. (2015). Synfacts, 11(09), pp.0983-0983.

Rahman, N. (2015). Corporate Finance. North Ryde: McGraw-Hill Australia.

Real estate investment decision making – a review. (2012). Journal of Property Investment & Finance, 30(5).

Wo, Y. (2012). Decision-Making Model on Real Estate Investment. AMM, 157-158, pp.1230-1232.