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ABC Ltd, a U.K. multinational enterprise is contemplating making a foreign capital expenditure in South Africa. The initial cost of the project is ZAR50 million. The annual cash flows over the five-year economic life of the project are estimated to be ZAR13 million, ZAR18 million, ZAR25 million, ZAR10 million, and ZAR9 million. ABC Ltd’s cost of capital in pounds (Ã¢â€šÂ¤) is 7.5 percent. The long-run inflation rate is forecasted to be 4 percent per annum in the U.K. and 12 percent in South Africa. The current spot foreign exchange rate is ZAR/Ã¢â€šÂ¤ = 15.56.
(a) Calculate the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher Effect and then convert the ZAR NPV to Ã¢â€šÂ¤ at the current spot exchange rate.
(b) Convert all cash flows from ZAR to Ã¢â€šÂ¤ at Purchasing Power Parity forecasted exchange rates and then calculate the NPV at the pound cost of capital.
(c) What is the NPV in pounds if the actual pattern of ZAR/Ã¢â€šÂ¤ exchange rates is: S(0) = 15.56, S(1) = 14.56, S(2) = 16.72, S(3) = 15.78, S(4) = 16.54, and S(5) = 16.32? Explain the difference in the actual and the forecasted NPV.
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