Zimmer: Manufacturer Of Modular Rooms Plans To Expand

4zimmer A Manufacturer Of Modular Rooms Plans To Expand Its Operati

4zimmer, a manufacturer of modular rooms, plans to expand its operations in Landshut, Germany. The expansion will cost $14.5 million and is expected to generate annual net cash flows of €2.15 million for a period of 12 years. After this period, the operation will be sold for €1 million (net of taxes). The project’s cost of capital is 14%, and the forecast FX rate for the euro for the term of the project is $1.25/€. The task is to compute the net present value (NPV) of this expansion project, considering both the cash flows and the currency exchange rate.

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The expansion of 4zimmer, a modular room manufacturing company based in Landshut, Germany, presents a complex but potentially profitable opportunity. To determine whether this project should be pursued, a comprehensive financial analysis involving the calculation of the net present value (NPV) is crucial. The NPV calculation involves discounting all cash flows associated with the project, including annual net cash flows and the terminal sale value, to their present value. This analysis is further complicated by the involvement of foreign currency exchange risks, given that the cash flows are denominated in euros, while the investment and valuation are expressed in U.S. dollars.

The initial investment in the project is $14.5 million, which will be used to fund the expansion. The project is projected to generate €2.15 million annually for 12 years. At the end of Year 12, the operation will be sold for €1 million. To accurately evaluate the project's NPV in dollar terms, cash flows in euros must be converted into dollars using the forecasted exchange rate of $1.25/€. Furthermore, the discount rate applied should reflect the project's required rate of return, which is 14%, providing a present value of future cash flows in dollar terms.

Calculating the Present Value of Cash Flows

The annual net cash flow in euros is €2.15 million. Converting this into dollars using the forecast exchange rate yields:

Annual cash flow in dollars = €2.15 million × $1.25/€ = $2.6875 million

This amount will be received annually for 12 years. To determine the present value of these cash flows, the formula for the present value of an annuity is applied:

PV of annuity = C × [(1 - (1 + r)^{-n}) / r]

Where:

  • C = $2.6875 million (annual cash flow)
  • r = 14% or 0.14 (discount rate)
  • n = 12 years

Calculations:

PV of cash flows = $2.6875 million × [(1 - (1 + 0.14)^{-12}) / 0.14]

Calculating (1 + 0.14)^{-12} ≈ 0.277, so:

PV of cash flows ≈ $2.6875 million × [(1 - 0.277) / 0.14] ≈ $2.6875 million × [0.723 / 0.14] ≈ $2.6875 million × 5.164 ≈ $13.888 million

Calculating the Terminal Sale Value

At the end of 12 years, the operation will be sold for €1 million. Converting this into dollars gives:

Sale proceeds in dollars = €1 million × $1.25/€ = $1.25 million

The present value of this amount discounted back 12 years is:

PV = $1.25 million / (1 + 0.14)^{12}

(1 + 0.14)^{12} ≈ 3.648, thus:

PV ≈ $1.25 million / 3.648 ≈ $342,500

Calculating the Total NPV

The total NPV is obtained by summing the present values of the annual cash flows, the present value of the terminal sale, and subtracting the initial investment in dollars:

Initial investment in dollars = $14.5 million

NPV = (PV of annual cash flows + PV of terminal sale) - initial investment

NPV = ($13.888 million + $0.3425 million) - $14.5 million ≈ $14.2305 million - $14.5 million ≈ -$0.2695 million

Therefore, the NPV of the expansion project is approximately -$269,500, indicating that, based on these assumptions, the project would decrease value and might not be financially viable.

Considerations and Implications

This conclusion hinges on several assumptions, including the accuracy of the forecasted exchange rate and stable cash flows. Currency risk can significantly affect project valuation, and hedging strategies could mitigate some of this risk. Moreover, sensitivity analysis varying key parameters such as exchange rates, discount rates, or cash flow estimates would provide a comprehensive understanding of the project's viability.

In real-world decision-making, managers must evaluate whether qualitative benefits, strategic alignment, or potential future market expansion justify proceeding despite a marginal or negative NPV. Additionally, engaging in currency risk management could alter the project’s financial outcome.

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