Louisville Co. is a U.S firm considering a project in Austria which is has an initial cash outlay of $7 million. Louisville will accept the project only if it can satisfy its required rate of return of 18 percent. The projct would definitely generate 2 million euros in one year from sales to a large corporate customer in Austria. In addition, it also expects to recieve 4 million euros in one year from sales to other customers in Austria. Louisville’s best guess is that the euro’s spot rate is $1.26 in one year. Today, the spot rate of the euro is $1.40, while the one year forward rate of the euro is $1.34. If Lousiville accepts the project, it would hedge all the receivables resulting from sales to the large corporate customer but none of the expected receivables due to expected sales to other customers.
A. Estimate the net present values of the project.
B. Assume that Lousiville considers alternative financing for the project in which it would use $5 million cash while the remaining initial outlay would come from borrowing euros. In this case, it would need 1,600,000 euros to repay the loan (principal plus interest) at the end of one year. Assume no tax effects due to this alternative financing. Estimate the NPV of the project under these conditions.
C. Do you think the Lousiville’s exposure to exchange the rate risk due to the project if it uses the alternative financing (explained in part b) is higher, lower, or the same as if it has an initial cash outlay of $7 million (and does not borrow any funds)? Briefly explain.
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