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.