QUESTIONS

l. What is meant by the term "overvalued"? If the pound is overvalued by

20 percent, is it reasonable to expect it to remain overvalued for seven
years? What actions might the Arabian government take to preserve the
current exchange rate?
2. Management wants to recalculate the projects NPV and IRR if at the
beginning of year 2 the Arabian pound is devalued 20 percent, which
they assume will result in a 20 percent increase in revenue as well as
material, labor, and shipping costs.
(a) Recalculate the NPV under these assumptions. You may assume for
the moment that the plant still sells for 3.4 million Arabian pounds at
the end of the project. (The IRR is 20.9 percent.)
(b) Are management's assumptions reasonable? Defend your answer.
3. Who's right about the value of the plant? Would the reproduction cost of
the plant be higher or lower after devaluation? What is the NPV if the
final sale value is unchanged in terms of U.S. dollars (i.e., the price in
Arabian pounds increases 20 percent from 3.4 to 4.08 million pounds)
and there are no other changes in the financial estimates used in question
2?
4. Should the tax losses from Letho be considered part of the project?
Or should they be treated separately? Under what circumstances should
they be treated each way?
5. What is a floating exchange rate? The exchange rate between the Arabian
pound and the dollar is "fixed" while the exchange rate between
European currencies and the dollar is the result of a "dirty float" or
"managed float." Give the meaning of each term.
6. (a) Is it reasonable to assume that exchange rates between the U.S. and
Europe will remain constant?
(b) How would the projects NPV be affected if the dollar rose 10
percent compared to the average European exchange rate? You may
assume that the only effect from the base ease would be a 10 percent
change in the dollar value of European sales. (The IRR would be
30.6 percent.)
(c) The NPV would be -$2,592(000) and the IRR 5.0 percent if the dollar
were to fall 10% percent relative to the average European exchange
rate.
7. If a forward market existed, could Evelast use it to protect itself from the
risk of the dollar moving against European currencies?
8. If there were no forward exchange rate, how might Everlast protect itself
against fluctuations in a European currency?
9. Suppose the project becomes valueless at the end of the second year (ie.,
at the end of year t + 2) because of war, expropriation, or natural
catastrophe. Make appropriate adjustments to the cash flows shown in
Exhibit l, and calculate the NPV of this scenario. (The IRR is -42
percent.)
10.
(a) Assume there is a 5 percent chance that the "disaster scenario"
in question 9 will occur. Calculate a weighted average of the IRRs
given in Exhibit l and question 9.
(b) Using the same weights, a weighted average of the cash flows
results in an IRR of 17.4 percent.
(c) Which is the correct method for calculating the weighted average
of the IRRs? Explain.
11. Based on your calculations, do you believe the company is justified in
using a 15 percent hurdle rate for this project? What adjustments
would you make?
12. Would you recommend that the firm undertake this project? Defend
your recommendation.