Groupe Ariel SA: Parity Conditions and Cross-Border Valuation
Hints to case study questions:
1. Compute the NPV of Ariel-Mexico's recycling equipment in pesos by discounting incremental peso cash flows at a peso discount rate. How this NPV should be translated into Euros? Assume expected future inflation for France is 3% per year.
1.1. Review principles of estimating project cash flows. Suggested reading: Ch. 9 “Capital Budgeting and Cash Flow Analysis” in “Contemporary Financial Management”, 11th ed. by Moyer, McGuigan, and Kretlow.
a. Project Net Investment (NINV):
NINV=Capital Expenditure-ATSVold ,
where ATSVold = After-Tax Salvage Value of the old equipment. ...view middle of the document...
Calculate total peso cash flows over time.
1.3. In order to estimate the peso discount rate, assume that the International Fisher Effect (IFE) holds. Groupe Ariel's Euro hurdle rate for a project of this type was 8%. Assume that inflation rates are expected to be 7% in Mexico and 3% in France.
1.4. Project NPV:
2. Compute the NPV in Euros by translating the project's future peso cash flows into Euros at expected future spot exchange rates. Note that Groupe Ariel's Euro hurdle rate for a project of this type was 8%, assume that inflation rates are expected to be 7% in Mexico and 3% in France.
To derive expected peso/euro exchange rates, assume the Purchasing Power Parity (PPP)
3. Compare the two sets of calculations and the corresponding NPVs. How and why do they differ? Which approach should Ariel's financial analyst use?
4.1. If the IRP, PPP, and International Fisher Effect conditions hold, the two approaches should yield identical NPV results.
4.2. If one or more parities do not hold, the two approaches will give very different results, possibly causing managers at the French headquarters and in the Mexican subsidiary to disagree about whether the project should be undertaken.
4. Suppose Mexican inflation is projected at 3% instead of 7% per year (assume French inflation remains 3%). How does this affect the NPV calculations?
5.3. Recalculate incremental cost savings at the lower Mexican inflation rate of 3%. Use Exhibit 2 of the case.
a. Assume materials costs/unit, direct labor costs/unit, overhead costs stay the same in 2009.