Catoon Co Is Considering The Acquisition Of A Unit From The

Cantoon Co Is Considering The Acquisition Of A Unit From The French G

Cantoon Co. is evaluating the financial viability of acquiring a unit from the French government, considering both cash purchase and partial financing options. The initial outlay for the acquisition is $4 million, with the expectation that all earnings will be reinvested into the unit. The anticipated sale price at the end of 8 years is 12 million euros after taxes, with the current spot rate of the euro being $1.20. The project’s discounted cash flow analysis employs a discount rate of 20%, reflective of Cantoon’s cost of capital, and assumes no foreign exchange hedging strategies are in place. Additionally, the scenario considers the opportunity of financing part of the purchase using a euro-denominated loan, along with the appropriate derivation of the 8-year forward rate based on interest rate parity principles. This comprehensive financial assessment explores the net present value (NPV) under different financing structures by incorporating exchange rate forecasts, interest rate differentials, and currency risk considerations.

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In analyzing Cantoon Co.’s proposed acquisition from the French government, it is essential to understand the key financial components involved, including initial investment costs, future cash flows, exchange rate risks, and financing options. This evaluation encompasses both a straightforward cash purchase and a partial financing approach, integrating foreign exchange considerations through both spot and forward rate forecasts, and factoring in the cost of capital and interest rate differentials.

Initially, assessing the unhedged cash purchase scenario presents a base case for the project’s viability. The initial outlay is $4 million, and the expected future sale is 12 million euros after 8 years. Given the current spot rate of $1.20/€, the future euro cash inflow in dollar terms is calculated as:

12 million euros × $1.20/€ = $14,400,000.

The present value (PV) of this future sum, discounted at a required return of 20% over 8 years, is computed using the discount factor of 1/(1+0.20)^8 ≈ .232, which results in PV of:

$14,400,000 × .232 ≈ $3,340,800.

Thus, the net present value (NPV) considering the initial outlay is:

NPV = $3,340,800 – $4,000,000 = –$659,200, indicating a negative NPV if financed completely with cash, suggesting the project might not be profitable under these assumptions.

Next, the analysis explores partial financing, where the company borrows 3 million euros to reduce the initial cash outlay. The company will repay a lump sum of 7 million euros after 8 years, which includes the principal and accrued principal repayment—implying no interest payments. The critical aspect here is forecasting the future exchange rate to determine the dollar value of the repayment amount and subsequently assessing the project’s NPV under this financing structure.

To derive the 8-year forward rate, interest rate parity (IRP) is employed, which relates the spot rate, interest rates of the two currencies, and the forward rate. The risk-free rates are 5% for USD and 7% for EUR. The forward rate (FR) calculation using IRP is based on:

Forward rate = Spot rate × (1 + interest rate of domestic currency) / (1 + interest rate of foreign currency).

Expressed numerically:

FR = $1.20 × (1.05)^8 / (1.07)^8 ≈ $1.20 × 1.477 / 1.850 ≈ $1.20 × 0.798 ≈ $1.0338.

This indicates that the euro is expected to appreciate slightly over the 8-year horizon. Using this forward rate, the expected dollar amount of the 5 million euros net of the loan repayment becomes:

5 million euros × $1.0338 ≈ $5,169,000.

The present value of this future cash inflow, discounted at a 20% rate over 8 years, is:

$5,169,000 × .232 ≈ $1,202,144.

Since the company borrows 3 million euros, which are equivalent to:

3 million euros × $1.20 = $3,600,000, the company finances part of the initial outlay accordingly.

The remaining initial out-of-pocket expense is:

$4,000,000 – $3,600,000 = $400,000.

Finally, the NPV of this financing approach is calculated by subtracting this outlay from the present value of the future cash inflow:

NPV = $1,202,144 – $400,000 ≈ $802,144.

This positive NPV suggests that partial financing using a forward rate forecast enhances project viability by reducing the initial cash investment and leveraging favorable exchange rate expectations.

Overall, the financial analysis indicates that without hedging, the project yields a negative NPV, but combining partial financing with exchange rate forecasting via forward rates significantly improves its attractiveness. It underscores the importance of strategic international financial management, particularly in managing currency risks and optimizing capital structure to maximize project value.

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