SCS – Nov 2023 – L3 – Q5a – International Financial Management

Determine forward rates using interest rate parity and calculate the NPV for an international investment project.

Question

In connection with the proposed investment in the United Kingdom by NSL for shito production in that country, the shareholders require information to make the final investment decision.

Required:
i) Using the interest rate parity formula/equation, determine the forward rates/future spot rates at the end of 2024, 2025, 2026, and 2027.
(4 marks)

ii) Calculate the net present value(s) for the project at the beginning of 2024 that will determine whether the project should be accepted by the shareholders. Advise the shareholders whether they should accept and proceed with the project or reject it.
(7 marks)

Answer

Formula:
$F=S0×(1+id1)\{1 + i_d}{1 + if}$

Where:

$F$ = Forward rate/future spot rate
$S_0$ = Current spot rate (GH¢15.25/£1)
$i_d$ = Domestic interest rate (Ghana 15%)
$i_f$ = Foreign interest rate (UK 8%)

Forward Spot Rates:

Year	Formula	Forward Spot Rate
End of 2024	15.2500 × ((1.15)/(1.08))	16.2384
End of 2025	15.2500 × ((1.15)/(1.08))^2	17.2909
End of 2026	15.2500 × ((1.15)/(1.08))^3	18.4116
End of 2027	15.2500 × ((1.15)/(1.08))^4	19.6050

(4 marks)

ii) Calculation of Net Present Values (NPV)

Stage 1: NPV in the United Kingdom
Discount rate: 8%

Year	Cash flows (£)	Discount Factor @ 8%	Present Value (£)
Start 2024	(200,000)	1	(200,000)
End of 2024	65,000	0.9259	60,183.50
End of 2025	65,000	0.8573	55,724.50
End of 2026	65,000	0.7938	51,597.00
End of 2027	65,000	0.7350	47,775.00

Total NPV in the UK: £15,280

Stage 2: NPV for NSL (Parent Company) in Ghana
Using the forward rates calculated earlier, the UK cash flows are converted to Ghanaian cedi at the end of 2027. Cash flows for years 1–3 remain in the UK and will be transferred at the end of year 4 at the rate of GH¢19.6050/£1.

Decision: The project should be accepted if the NPV is positive after considering both stages.

(Marks allocation: Forward rates @ 4 marks, NPV calculation and advice @ 7 marks = 11 marks)

Tags: Forward Rates, Interest Rate Parity, International Investment, NPV
Level: Level 3

Series: NOV 2023

Uploader: Dotse