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Following is my query in Okan Co (Sep/Dec 19) model answer “Working 3 – Component Cost” :-
Information given at T0-
The expected spot exchange rate between Y$ and GBP , In Six Month’s time is expected to be Y$ 3.03 per GBP.
The Annual inflation rates are currently 2% in UK and 4% in Yasailand.Hence the forecast of Y$ per GBP at T1 should be 3.03 *(1.02/1.01) = 3.06 .Note- I have considered inflationof only 6 months here as the rate 3.03 is the rate at T0.5.
BUt the model answer considers the full year’s inflation on the T0.5 (six month) rate.
The examiners answer is correct.
The project starts in 6 months time, (which is time 0), and the first operating cash flows will occur 12 months after the start (i.e. in 18 months time) and so this is time 1.
The exchange rate in 6 months time is expected to be 3.03, and therefore the exchange rate 12 months after that will be 3.03 x (1.04/1.02)
To estimate the future exchange rate using purchasing power parity = So*((1+ foreign inflation)/(1+local inflation)). But why in this question the position of inflation is the other way round ? Which company’s POV we are looking at ?
It is not as you have typed it, and it depends on which way round the exchange rate is quoted and not on where the particular company is based.
It is So x (1+ ‘other’ currency inflation) / (1 + base currency inflation).
The base currency is the currency against which the other currency is being quoted.
Here, the exchange rate is quoted against the Pound and so Pound is the base currency and Y$ is the ‘other’ currency.
This is all explained, with examples, in my free lectures on forecasting future exchange rates.
Hi,
you say “the first operating cash flows will occur 12 months after the start ” ?
But in the exhibit 4 it is written “the sales and production in six months time are estimated as follows”
Therefore, the components costs given are also in 6 months time.
Therefore, the T1 component costs should be translated with the expected spot exhange rate in 6 months time which is 3.03 and not 3.03 *(1.02/1.01) = 3.06
no?No, because the question says that they are the estimates in six months time.
I don’t understand?
my question refers mainly to the fact that we are T1 in 6 months time so to use the expected spot echange rate in 6 months time and therefore no need to : 3.03 *(1.02/1.01)
since 3.03 is in six monthsThe flows are given in 6 months time, but the requirement asks for the NPV in 6 months time.
So T0 is in 6 months time and all the flows from then on are at yearly intervals.Yes, so since the flows are in 6 months time and that i already have the expected spot echange rate in 6 months time of 3.03:
I do not need to do –> 3.03 *(1.02/1.01) to find the rate for in 6 months time since it is given and is 3.03…. 🙁
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