Memorandum Ariel Case

Topics: United States dollar, Mexican peso, Inflation Pages: 7 (909 words) Published: April 29, 2015
Memorandum
To:                  Prof. Bruce G. Resnick
From:             Thibault Usson, Peidan Wu, Jerry Zhang, and Li Zhang Date:              April 27, 2015
Re:                  Group Ariel Parity Conditions and Cross-Border Valuation Group Ariel, a global manufacturer of printing and imaging equipment, has to evaluate a proposal from its Mexican subsidiary to purchase and install a new cost-saving machinery at a manufacturing facility in Monterrey. This new equipment will allow automating recycling and remanufacturing of toner and printer cartridges, and would have a useful life of 10 years. To analyze the investment proposal, Group Ariel needs to conduct a DCF analysis and run an estimate for the Net Present Value (NPV) for capital expenditures. However, the company needs to keep in mind the exchange rate between Mexican Pesos and Euros, as well as the inflation rates over time and the risks involved with this type of investment. Indeed, a major challenge for the analysis will be deciding which currency to use between the Euro and the peso. Scenario #1: Mexican Inflation = 7%

Given the fact that the expected future inflation is 7% for Mexico and 3% for France. The discount rate used for the Peso NPV can be calculated using the equation for the International Fisher Effect: WACC-Mexico = 12.19% ·       Method A: NPV in pesos and then in Euros.

The NPV in Pesos = 1,478,505[1] and using this NPV, we can translate it into Euros using the current MXN15.99/EUR exchange rate. The NPV in Euros is €92,464.

[1] See Exhibit 1.
·       Method B: NPV in Euros.
Assume that PPP and Fisher Equation holds, then we can get the future spot rate of exchange for each year and conclude the NPV in Euros at €92,464[2] ·        Conclusion:
The NPV of this equipment investment would be same whether we use Method A or Method B as long as IRP and PPP hold. Arnaud Martin should therefore not have any preference between the two methods. Both computed NPVs are positive, so Group Ariel should definitely approve the project in those circumstances. Scenario #2: Mexican Inflation = 3%

In this scenario, Mexican inflation is now projected at 3% instead of 7% per year. Similarly, the discount rate used for the Peso NPV can be calculated using the equation for the International Fisher Effect: WACC-Mexico is now equal to 8%. ·       Method A: NPV in pesos and then in Euros.

The NPV in Pesos = 1,770,029 [3] and using this NPV, we can translate it into Euros using the current MXN15.99/EUR exchange rate. The NPV in Euros is €110,691.60. ·       Method B: NPV in Euros.
The NPV in Euros is €110,691.60 [4]

[2] See Exhibit 2.
[3] See Exhibit 3.
[4] See Exhibit 4.

·       Conclusion:
By changing the Mexican inflation from 7% to 3%, we find that the future spot rate of exchange will keep at MXN15.99/EUR over the period, which is smaller than ‘Scenario #1’. This change in the projection of the Mexican inflation positively affected the NPV of the project. NPVs are also the same no matter how we compute it, as long as IRP & PPP hold. Again, Group Ariel should approve the project. Scenario #3: Mexican Inflation = 3% & Depreciation of the peso. A more realistic scenario would be to take into account the sudden change of the expected exchange rate between the Peso and the Euro. Indeed, many analysts thought that a depreciation of the peso was very likely, and they forecast a rise in the MXN/EUR rate to 20.00 by 2011 and to even more than 25.00 starting from 2013. If inflation remains the same at 3% in both countries, the FX rate shall not change when PPP holds and hurdle rate should still be 8% for both currency. However, in this situation, a significant real depreciation of the peso against the Euro will occur, the FX rate will change accordingly, which means that PPP and Fisher Equation do not hold. Using the first approach, the NPV of the project will not change, as it computes with the current exchange rate and does not take into...
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