Net Present Value and Discounted Cash Flow

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CASE #2 – “Groupe Ariel: Parity Conditions and Cross-Border Valuation”

Written reports are to be no more than five typed pages (based on a 12-point Times New Roman font, double-spaced, with 1-inch margins all around). The assignments are due at the beginning of class on Thursday, November 8, 2012.

This case is designed to introduce discounted cash flow valuation techniques in a cross-border setting. Groupe Ariel’s Mexican subsidiary is proposing the purchase and installation of some cost-saving equipment in its plant in Monterrey. The headquarters at Ariel requires a discounted cash flow analysis and an estimated net present value for expenditures of this magnitude. The issue is whether the analysis should be performed in euros or pesos. Relevant cash flows and appropriate discount rates are the focus in this introduction to cross-border capital budgeting. Industry and competitive analysis, international tax factors, remittance policies, etc. may be ignored.

Answer the following questions in your report:
1. Compute the net present value of Ariel-Mexico’s recycling equipment in: (i) Mexican pesos, by discounting peso cash flows at a peso discount rate (“Method A”); and (ii) euros, by translating future peso cash flows into euros at the expected future spot exchange rates (“Method B”). Assume that Ariel’s hurdle rate in France for a project of this type is 8%. Also assume that at the time of analysis, the annual expected inflation is 7% in Mexico and 3% in France. What do you conclude with respect to the NPVs from using the two different valuation approaches? Are they the same? Why or why not?

2. Suppose the Mexican inflation is the same as that in France (i.e. 3%), and both RPPP and UIP continue to hold. Redo the analysis in Question 1. What do you conclude?

3. Assume the same inflation scenario as in Question 2. However, suppose that PPP breaks down (so,...
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