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Groupe Ariel S A Parity Conditions and Cross Border Case Solution

Solution Id Length Case Author Case Publisher
1313 1278 Words (6 Pages) Timothy A. Luehrman, James Quinn Harvard Business School : 4194
This solution includes: A Word File A Word File and An Excel File An Excel File

The hurdle rate is the minimum rate of return required an investment for it to be approved for execution by the company. To calculate the hurdle rate in pesos, it was assumed that the International Fisher Equation holds. The hurdle rate for Groupe Ariel’s France operations was given to be 8% while the inflation rate in France and Mexico were 3% and 7% respectively. Using International Fisher Equation, we have:

Discount Rate (Peso) = (1 + Inflation rate Mexico) x (1 + Inflation rate France) x (1 + Real Interest rate Mexico)

Following questions are answered in this case study solution

  1. Assume 3% inflation going forward in France. Based on this assumption and the information contained in the case, what hurdle (discount or cost of capital) rate, in pesos, would you use to discount the cash flows from the project? Show your calculations and assumptions.

  2. Compute the project cash flows in pesos for years 0 through 10 and calculates the NPV in pesos. Calculate the IRR of the project. Show your calculations and assumptions in detail. Should the project be accepted or rejected?

  3. Convert the Peso NPV to Euros at the June 23, 2008 spot exchange rate. Show your calculations.

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Case Analysis for Groupe Ariel S A Parity Conditions and Cross Border

The real interest rate in the exhibit gives the rate for the entire year while the analysis is being done after half the year has been passed. So the real interest rate has been divided by two for the calculation.

Discount Rate (Peso)

12.19%

(1 + Inflation rate Mexico) x (1 + Inflation rate France) x (1 + Real Interest rate Mexico)

Inflation in France

3%

 

Inflation in Mexico

7%

 

Interest Rate Real

1.80%

 

The hurdle rate in Pesos comes out to be 12.19% for a project of this nature.

Compute the project cash flows in pesos for years 0 through 10 and calculates the NPV in pesos. Calculate the IRR of the project. Show your calculations and assumptions in detail. Should the project be accepted or rejected?

The project under consideration is a replacement project. Replacement projects are mutually exclusive projects, and only one option from a given set of options survives. In the given case, Groupe Ariel is considering a recycling project in Mexico and the financial analyst needs to submit his analysis in a day. The important considerations in the analysis of this project are as follows:

  • The exchange rate between the two countries (Mexico and France, MXN/Euro).

  • Cash flow from existing manual process.

  • Cash flow from the automated process.

  • The difference between the cash flows from the two processes.

  • Tax rates of two countries.

  • Depreciation changes resulting from the changed process.

  • Changes in the working capital requirements.

  • The salvage value of the old equipment.

  • Book value of the old equipment.

  • The cost of a new machine.

  • Salvage value of the new machine at the end of its useful life.

  • The discount rate at which the cash flows will be discounted.

The project shall be evaluated based on the net present value (NPV) of the project. All the considerations listed above are the important inputs for the calculation of the net present value. We begin the analysis by calculating the net investment required for the new equipment. It is important to note that the salvage value of the old equipment will result in reducing the cost of the project’s initial investment and needs to be deducted from the cost of new equipment. Following is the list of inputs required to calculate the Net Investment:

  • Salvage value of old equipment

  • Cost of new equipment

  • Tax impact on sale of old equipment

  • Changes in net working capital

We have been told that there are no significant changes in Net Working Capital requirements and can thus be ignored for the analysis. So, to calculate the net investment, we use the following formula:

Net Investment = Cost of new machine – Market value of old machine ± (Market value of old machine – Book value of old machine)* x Tax Rate

*If market value is greater (lower) than the book value, then the tax impact increases (decreases) the net investment.

Item

Amount (MXN)

Net Cash Flow

(3,351,250)

New Equipment Cost

3,500,000

Old Equipment Market Value

175,000

Old Equipment Book Value

250,000

Tax Saving (Loss) on Sale of Old Equipment

26,250

Initial Investment (less market value of existing manual system and incorporating tax impact)

3,351,250

To calculate the incremental cash flows, the difference in cash inflows from both projects is taken into account by simple subtraction. To calculate incremental depreciation, the difference between the depreciation of both machines have been taken into account. It has been mentioned in the case that the old equipment has a remaining useful life of 3 years and thus the impact of depreciation has been accounted for in the next three years only. This has to be noted, however, that depreciation is a non-cash expense and does not impact net cash flows directly. Depreciation impacts the net cash flow via tax impact. Depreciation is a tax-deductible expense and reduces the amount of tax resulting in tax savings.

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