A U.S.- based firm, is considering a five- year project in Turkey. The following information is available about the project:
Initial investment. The initial investment of USD 750,000 is used to purchase capital equipment. This equipment will be depreciated straight line to zero. At the end of five years, the remaining equipment will be sold for Turkish lira (TRY) 250,000.
Working capital. The investment in working capital is TRY 200,000. There are no changes in working capital until the end of the project when the full amount is recovered.
Units, price, and costs. The firm will produce 1,250 units of a product annually. The selling price is expected to be TRY 600 in the first year. This price is expected to increase at a rate of 6 percent annually. The direct expense per unit is expected to be TRY 150 in the first year. This is expected to increase at a rate of 8 percent annually. Indirect expenses are expected to be TRY 65,000 annually.
Taxes and miscellaneous. Turkish taxes on income and capital gains are 33 percent. There are no additional withholding taxes. All cash flows are repatriated when generated, and there are no additional U. S. taxes. The parity conditions are assumed to hold between Turkey and the UnitedStates. The relevant inflation indexes indicate a rate of 3 percent for the United States and 5 percent for Turkey. Spot USDTRY equals 2.5. BradyAc€?cs USD denominated WACC is 12 percent.
QUESTION: Now assume that the TRY rate of annual depreciation doesn't follow parity conditions. What is the break-even rate of depreciation in TRY? Assuming the USD inflation is unchanged, what is the TRY inflation rate consistent with this break-even depreciation?