The Wheel Deal Inc., a company that produces scooters and other wheeled non-motorized recreational equipment is considering an expansion of their product line to Europe. The expansion would require a purchase of equipment with a price of €1,200,000 and additional installation of €300,000 (assume that the installation costs cannot be expensed, but rather, must be depreciated over the life of the asset). Because this would be a new product, they will not be replacing existing equipment. The new product line is expected to increase firm’s revenues by €600,000 per year over current levels for the next 5 years, however; expenses will also increase by €200,000 per year. (Note: Assume the after-tax operating cash flows in years 1–5 are equal, and that the terminal value of the project in year 5 may change total after-tax cash flows for that year.) The equipment is multipurpose and the firm anticipates that they will sell it at the end of the five years for €500,000. The firm’s required rate of return is 12% and they are in the 40% tax bracket. Depreciation is straight-line to a value of €0 over the 5-year life of the equipment, and the investment also requires an increase in NWC of €100,000 (to be recovered at the sale of the equipment at the end of five years). The current spot rate is $0.95/€, and the expected inflation rate in the U.S. is 4% per year and 3% per year in Europe.
a) What are the annual after-tax cash flows for the Wheel Deal project?
b) In euro, what is the NPV of the Wheel Deal expansion?
c) What is the IRR of the Wheel Deal expansion?
d) What is the NPV of the European expansion if Wheel Deal first computes the NPV in euro and then converts that figure to dollars using the current spot rate?
e) Show that the European expansion would have a greater NPV in dollar terms if the euro appreciated in value over the five-year life of the project, other things equal.