International operations and international investment appraisal

Hi John, Question: A manufacturing company based in the United Kingdom is evaluating an investment project overseas – in REBMATT a politically stable country. It will cost an initial 5.0 million REBMATT dollars (RM$) and it is expected to earn post-tax cash flows as follows: Year 1 2 3 4 Cash flow RM$'000 1,500 1,900 2,500 2,700 The following information is available: ? Real interest rates in the two countries are the same. They are expected to remain the same for the period of the project. ? The current spot rate is RM$ 2 per £1. ? The risk-free rate of interest in REBMATT is 7% and in the UK 9%. ? The company requires a UK return from this project of 16%. Required: Calculate the £ net present value of the project using the standard method i.e. by discounting annual cash flows in £. Solution: Calculation of exchange rates Using the interest rate parity theory: Year 1 2.00 × 1.07/1.09 = 1.9633 Year 2 1.9633 × 1.07/1.09 = 1.9273 Year 3 1.9273 × 1.07/1.09 = 1.8919 Year 4 1.8919 × 1.07/1.09 = 1.8572 Doubt: Why have we taken 2.00 in the numerator, shouldn't it be 0.5? I mean spot rate is RM$ 2 per £1 i.e. RM$/£ = 0.5.