This case discusses Cross-Border valuation of projects. This kind of analysis is common for companies that are operating in many countries. Groupe Ariel is one such company that is considering investing in a project in its own subsidiary in Mexico. The company manufactures and sells printers, copiers and other document production equipment in many countries. As far as, expansion into new markets is concerned, company is very slow in taking initiatives as compared to its competitors owing to the recent recession. But the management of the company believes that better durability and lower after-sales service costs of their products enable the company to build customer loyalty. The company is now considering replacing the manual equipment used for recycling in Mexico by new equipment that requires less material and labour costs. But, the uncertainty linked with certain macroeconomic factors like exchange rate, inflation and interest rate has made the valuation of the project very complex.
NPV Analysis (Peso)
Hurdle rate for Peso
TimeCost of purchasing the equipment
After tax Cash inflow from the sale of Manual equipment
After tax depreciation DepreciationCost savings from New equipmentTotal Cash flows
PV of cash flows
NPV Analysis (Euros)
Discount rate in France
Expected Inflation in France
Expected Inflation in Mexico
Total Cash flows in Euros
PV OF CASH FLOWS
NPV IN EUROSTotal cash flows
PV OF CASH FLOWS
NPV IN EUROS
Compute the NPV of Ariel-Mexico’s recycling equipment by counting incremental peso cash flows at a peso interest rate. How should this NPV be translated into Euros? Assume expected future inflation for France is 3% per year.
Compute the NPV in €s by translating future peso cash flows into €s at expected future spot rates. Note Ariel’s € hurdle rate for this asset class was 8%. Annual inflation rates are expected to be 7% in Mexico and 3% in France.
Compare the two sets of calculations and the corresponding NPVs. How and why do they differ? Which approach should Arno Martin use? Relate your answer to the textbook’s treatment of parity disequilibria in capital budgeting.
Suppose Mexican inflation is projected at 3% instead of 7% per year. Assume French inflation remains at 3%. How does this affect the NPV calculations?5. Suppose Ariel expects a significant real depreciation of the peso against the Euro. How should Martin incorporate this expectation into his NPV analysis? For simplicity, assume inflation is expected to be 3% in each country. What is its affect on NPV under each of the approaches in questions 1 and 2?6. Firms can face violations of the parity conditions in addition to the parity violation in Question
What might these violations be, and what might be their consequences?
Are there any real options embedded in Ariel’s decision? What is a real option, anyway?
Should Group Ariel approve the equipment to purchase?