Statement of problem:
1. First of all Martin have to find out if the company should improve the equipment. 2. If they decide to improve, then, which currency should they make the purchase in? 3. How can they calculate what their expected rate of return at the most certainty? Analysis:
The general question is if the company should make the improvement or not, and if they do (assuming the project is beneficial) which currency will give the highest profit? Since it is calculated that the cost will drop when implementing the new equipment, we assumed that the cash flow equals the difference between the two figures. The NVP is 2,960,532 pesos, but Martin wanted to know whether to make the investment in Euros or Pesos. When we calculated the NPV in euros we can use two different approaches. You can find the NPV (Euro) by either translate NPV (Peso) by dividing it by 15,99.
However, the better solution is to use the expected future spot rate on every cash flow, because this estimate is more accurate. Inflation rate is important to look at because, if the inflation rate changes, the NPV also changes and that will effect their decision. So, they have to consider the risk of inflation changes. If the inflation rate drops to 3% in Mexico, the purchase in Euros is more profitable, because the Peso is strengthened. Another variable to consider when deciding between Euros and Pesos is the risks concerning prediction of future currency rates. The short-term exposure, long-term exposure, the political risk and translation exposure could all affect the inflation. Recomendations :
The company should go through with the project, because the net present value is positive. However, they should choose which currency to purchase the equipment in carefully, due to the uncertainty of the exchange predictions. They need to take all the risks into account.