Zylon Co. is a U.S. firm that provides technology software for the government of Singapore. It will be paid S$7,000,000 at the end of each of the next five years. The entire amount of the payment represents earnings since Zylon created the technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the United States. Its other cash inflows (such as revenue) are expected to be offset by its other cash outflows (due to operating expenses) each year, so its profits on the Singapore contract represent its expected annual net cash flows. Its financing costs are not considered within its estimate of cash flows. The Singapore dollar (S$) is presently worth $.60, and Zylon uses that spot exchange rate as a forecast of future exchange rates.
The risk-free interest rate in the United States is 6 percent while the risk-free interest rate in Singapore is 14 percent. Zylonâ€s capital structure is 60 percent debt and 40 percent equity. Zylon is charged an interest rate of 12 percent on its debt. Zylonâ€s cost of equity is based on the CAPM. It expects that the U.S. annual market return will be 12 percent per year. Its beta is 1.5.
Quiso Co., a U.S. firm, wants to acquire Zylon and offers Zylon a price of $10,000,000.
Zylonâ€s owner must decide whether to sell the business at this price and hires you to make a recommendation. Estimate the NPV to Zylon as a result of selling the business, and make a recommendation about whether Zylonâ€s owner should sell the business at the price offered.
Assume this was a hw assignemt or on a test without notes for a college class. Good to learn in school?
Just use interest rate parity to derive future exchange rates ...convert cash flows to USD currency at future rates and use WACC to arrive at PV. For cost of equity use CAPM...What exactly is the issue with this one ??
Lemme give you something more interesting: Forget the data on rates etc. in your question..
For the same problem assume 10 year Singapore govt bond yield is 22%. A similar US treasury bond is at 10%. The annualized std deviation of the Straits Time Index in most recent year is 30%. The annualized std deviation of the Singapore govt's 10 year bond denominated in USD was 26%. Market risk premium in US is 7%. Risk free rate in US is 5.5%. The beta for the project is 1.3 on project fundamentals. How would you price the currency risk into the cost of equity..??
First determine the country risk premium, estimated as the sovereign country's default spread over U.S. equivalent bond.
Default spread over treasuries= Singapore govt bond 10yr. yield- U.S. 10 yr. yield = 22%-10%=12%, YTM is much better, but who cares.
Get a lambda to estimate firm's exposure to country risk: Lamda= (% of Z's revenue from singapore)/(% of a large local competitor's revenue from singapore)
Then, multiply Lambda to the country risk premium and add that to the cost of equity to incorporate country/currency risk. I ignored the std deviations, because it is just too impractical and sensitive to fundamental error.
But the most practical thing to do for emerging market companies is to always convert FCFF to U.S. dollars via forward rates/interest rate parities. For risk estimation, add the Lambda*country risk premium to the cost of equity and the country default spread to the cost of debt, and do the DCF.
If you doubt the cost of debt for the emerging mkt firm, use synthetic ratings in the U.S. based on coverage ratios, and Fitch/S&P would be glad to give you an approximate default spread.
Rd(emerging) = RiskfreeU.S.+ Firm Default Spread(based on synthetic ratings)+ Countrydefaultspread(from Moody's)
Put a put on the currency rate and that charge and divide it over equity.
lol jk. maybe later i got some exams to study for.
Correct
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