Problem Statement
Thomas Boyatt is concerned about Canadian investment project, that whether it would be worth investing in Canada, with specific concerns over exchange rates and number of potential contracts that would be sold through Canadian site.
Analysis
Timberland industry is growing in Canada and Geo Tech could provide services to Canadian timberland site from remote locations. However, due to the US Patriot Act, Canadian timberland owners are reluctant in providing access, specifically to a US based site, to their timberland sites.
Therefore, Geo Tech is considering investment in Canada to capture the timberland industry share and believes that it can convince Canadian timberland owners for using US sites after they are satisfied with the Canadian sites of Geo Tech. Thomas Boyatt, in association with one of his employees has gathered some financial data in respect of investment for establishment of Canadian site which includes: initial investment, life of the project, working capital requirements and number of contracts. Boyatt has specifically expressed his concerns over the number of contracts and exchange rate risk involved in foreign investment, such as investment in Canadian site. Geo Tech is operating from the US, therefore, inflow and outflow of Canadian dollars will be required to finance the Canadian investment, which will expose Geo Tech to exchange rate risk. Although an assistant of Boyatt has taken exchange rates estimates but they are based on some expert opinions that may be inappropriate. Moreover, cash flows of the project are expected to occur at different times during the year but for ease of the evaluation of project, cash flows are assumed to occur at the end of each year concerned. Additionally, the competition restricts Geo Tech’s ability to increase revenues from setup and annual licensing fee in line with the increase in cost due to inflation, therefore the revenue of project will not inflate over the project life.
Analysis of Canadian investment has been made using net present value (NPV) model. NPV analysis uses the projected net cash flows of the project over the life of project and discounts those cash flows using risk adjusted cost of capital to reflect the risk associated with the potential investment. Analysis of Canadian project, using assumptions made by Thomas Boyatt and based on the net present value (NPV) model, results in positive net present value of USD 83,317/-. Positive NPV states that opting into this project will add USD 83,317/- into Geo Tech’s value. However, this NPV has been calculated using different assumptions of Boyatt and his assistant, such as salvage value of equipment, inflation effect, exchange rate estimates and number of contracts sold.
Residual Value of Equipment
Residual value of equipment at the end of five year project life is assumed to be zero, however, the equipment can sell at the end of fifth year for Canadian Dollar (CAD) 100,000/-, which is equal to net present value of USD 38,388/- after adjusting for tax and exchange rates. However, the project is worthwhile and incorporating the NPV of residual value will further enhance the value of investment project.
Effect of Inflation
Since cash flows of the project are expected to occur over a five year period, hence, the cash flows are subject to inflation but as per the assumption of Boyatt, inflation effect has not been incorporated in calculation of NPV of USD83,317/-. However, the variable cost of operations is subject to inflation and NPV of inflation effect on variable cost will be equal to USD (22,081/-) which will decrease the NPV of project to USD 61,237/-. However NPV is still positive enough for the financial feasibility of Canadian investment project.
Purchasing Power Parity (PPP)
Geo Tech will be exposed to exchange risk while converting its outflows and inflows of Canadian Dollars (CAD) into USDs or vice versa, therefore it needs to be closely evaluated that estimates of forward exchange rates are not badly estimated. Moreover, NPV calculation is based on forecast and estimates of exchange rates provided by Boyatt’s assistant but for reasonable estimates, forward exchange rates need to be calculated using the purchasing power parity (PPP). Purchasing power parity calculates the forward exchange rates using inflation effect in home and overseas country, therefore, conversion of the project cash flows using exchanges rates based on purchasing power parity will enhance the project NPV by USD 20,676/-.
Other Assumptions
Additionally, the variable cost is assumed to be 65% and 20% of setup and licensing fee respectively, however, this could be high or low in reality; hence, this will affect the project cash flows in future. Moreover, working capital requirements are assumed to be 10% of total annual revenues, which could be different in reality.
Sensitivity of Exchange Rates
Sensitivity analysis reveals that NPV of the project is highly sensitive to movement in exchange rates and a slight adverse movement of 4.7% in exchange rates will force the NPV of the project fall to negative. Therefore, Geo Tech should look for a suitable ................................
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