Question

Question 5 Alliance Assets (AA) Ltd. is a Singapore firm that engages in exploring and developing tantalum and lithium mineral resources. It has a subsidiary in Western Australia that conduct mining operations. Suppose you are the chief financial officer of AA's Australian subsidiary. Presently, you are considering an investment opportunity in a lithium mine. The investment project can be started at a cost, it then produces a positive cash flow, but then it requires environmental clean-up before termination. The projected cash flows in Australian dollar (AUD) of the investment are as follow: Time (Year) Cash Flow (for Outflow; + for Inflow) -AUD 64,000,000 + AUD 160,000,000 -AUD 100,000,000 The required rate of return to a Singapore-based firm for a domestic project of similar level of risk is 20%. The current exchange rate for Singapore dollar (SGD) is 0.9828 AUD. The inflation rate in Singapore is 2% and in Australia is 6%. The interest rate in Singapore is 5% and in Australia is 9%. Assume that purchasing power parity holds. (a) What is the AUD-denominated internal rate of return (IRR) of the project? Would you invest in the project? (6 marks) (b) What is the SGD-denominated net present value (NPV) of the project? Would the parent firm AA invest in the project? (10 marks) What is the SGD-denominated IRR of this project? Would the parent firm AA invest in the project if it uses the IRR rule for investment decisions? Reconcile your answers for part (b) and (c) if they are different. (6 marks) (TOTAL: 22 marks) -END OF PAPER-

Answer 1

a. Australian dominated IRR

Internal rate of return is the interest rate that makes NPV of the project equal to zero

   Let IRR be r

   NPV=0

   -64000000+160000000/(1+r)+(-100000000)/(1+r)²=0

1000000[-64+160/(1+r)-100/(1+r)²]=0

   ( 160(1+r)-100)/(1+r)²=64 {by LCM}

   160+160r-100=64(1+r)²

By solving this equation,we get

IRR=25%

Calculation of NPV

Years	Cash Flow	DCF	PV of CF
0	-6,40,00,000.0	1	-6,40,00,000.00
1	16,00,00,000.00	0.833333	13,33,33,333.33
2	-10,00,00,000.00	0.694444	-6,94,44,444.44
NPV			-1,11,111.11

Since, NPV is negative it should not invest.

b. Calculation of SGD Denominated Cash flow and NPV

Years	Cash Flow	DCF	PV of CF	Rate*	SGD denominated
0	-6,40,00,000.0	1	-6,40,00,000.00	0.9828	-6,28,99,200.00
1	16,00,00,000.00	0.833333	13,33,33,333.33	0.945713	12,60,95,094.34
2	-10,00,00,000.00	0.694444	-6,94,44,444.44	0.910026	-6,31,96,244.22
NPV			-1,11,111.11		-349.88

Snce, NPV is negative it should not invest.

*inflation rate has been considered for calculation of rates

c.

Years	Cash Flow	Rate	SGD
0	-6,40,00,000.0	0.9828	-6,28,99,200.0
1	16,00,00,000.00	0.9828	15,72,48,000.0
2	-10,00,00,000.00	0.9828	-9,82,80,000.0
		IRR	25.00%

No, the answer did not vary i.e. the firm should not accept the project.