Question

unication CP 26-3 Communication Global Electronics Inc, invested $1,000,000 to build a plant in a foreign country. The labor and materials used in production are purchased locally. The plant expansion was estimated to produce an internal rate of return of 20% in U.S. dollar terms. Due to a currency crisis, the currency exchange rate between the local currency and the U.S. dollar doubled from two local units per U.S. dollar to four local units per U.S. dollar. Write a brief memo to the chief financial officer, Tom Greene, explaining the impact the currency exchange rate change would have on the project's internal rate of return if (1) the plant produced and sold all product in the local economy only and (2) the plant produced all product locally and exported all product to the United States for sale.

Answer 1

Foreign Country Investment: $ 1,000,000

Expected IRR= 20%

Because of currency crisis, the currency exchange rate between the local currency and U.S dollar doubled from 2 local units per U.S dollar to 4 local units per U.S dollar.

That is:

             Earlier 1 U.S $ = 2 local Units

             Now,    1 U.S $ = 4 local Units

The IRR is the rate of return that sets the Net Present Value (NPV) of all cash inflows and outflows of an investment equal to zero.

Plant produced and sold all product in the local economy only:

Currency exchange rate change would have NO impact on the project’s Internal rate of return because net effect of cash inflow and outflow will be zero as plant produced and sold all product in the local economy only.

Labor and Material used in Production that are purchased locally now become more expensive due to currency exchange rate but at the same time sale price of a product also increases because product is sold locally.

Plant produced all product locally and exported all product to united states for sale:

Appreciation in the value of U.S dollar leads to Export more Expensive. This will lead to lower demand for product and reduce their profit margin. At the same time, as product is produced locally there is also increase in production cost. This will lead to increase in IRR.