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- This topic has 1 reply, 2 voices, and was last updated 3 weeks ago by John Moffat.

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- February 26, 2023 at 2:39 pm #679629
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 = 1.8572Doubt: 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.

February 27, 2023 at 4:34 am #679673No. 2 is the numerator because RM is quoted against the Pound and therefore the Pound is the ‘base’ currency in the formula.

Have you watched my free lectures on forecasting future exchange rates?

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