The Foreign Currency Approach

Kihlstrom requires a nominal return of 10 percent on the dollar-denominated cash flows. We need to convert this to a rate suitable for euro-denominated cash flows. Based on the international Fisher effect, we know that the difference in the nominal rates is:

The appropriate discount rate for estimating the euro cash flows from the drill bit project is approximately equal to 10 percent plus an extra 2 percent to compensate for the greater euro inflation rate.

If we calculate the NPV of the euro cash flows at this rate, we get:

NPV€ = —€ 2 + € .9/1.12 + € .9/1.122 + € .9/1.123 = € .16 million

The NPV of this project is € .16 million. Taking this project makes us € .16 million richer today. What is this in dollars? Because the exchange rate today is € .5, the dollar NPV of the project is:

766 PART EIGHT Topics in Corporate Finance

This is the same dollar NPV that we previously calculated.

The important thing to recognize from our example is that the two capital budgeting procedures are actually the same and will always give the same answer.4 In this second approach, the fact that we are implicitly forecasting exchange rates is simply hidden. Even so, the foreign currency approach is computationally a little easier.

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