Question

Dent Enterprises (DE), a US-based medical research firm, has recently identified an island off the northeastern coast of Canada that it believes contains a large population of special spiders. The venom from these spiders will be used to fight a specific type of cancer that is unique to Europe. The owners of the island have offered to sell it to DE for USD 8 million. DE would also be faced with additional initial costs of USD 12 million to engineer the equipment that will extract the venom from the spiders. DE is an environmentally aware firm and has agreed to return the spiders to the island.

The spider population would provide enough venom to last for three years. The following information has been made available to DE:

Year	One	Two	Three
Revenues	USD 26 million	USD 28 million	USD 29 million
Operating Expenses (excluding depreciation)	USD 12 million	USD 15 million	USD 18 million
Depreciation Expense	USD 6 million	USD 2 million
Interest Expense	USD 1 million	USD 1 million	USD 1 million
Tax Rate	21%	21%	21%

Dent Enterprises has a required return on assets of 10.2%. DE will invest USD 2 million at the end year during the life of the project to plant spider friendly bushes and flowers, as well as construct a bird sanctuary on the south side of the island. DE expects to sell the island at the end of year 3 for USD 4 million.

Note these cash flows are denominated in USD, but the project involves a Canadian island and European clients. Discuss the complications that multiple currencies will have on the capital budgeting decision.

Answer 1

The complications that will arise due to multiple currencies are :

• Estimating the cost of capital is complex as there are three currencies involved. The USD required return may be quite different from the Europe required return for the same project of the same firm.
• The expected cash flows in USD may be quite different from the actual realized cash flows due to changes in exchange rates over the years.
• The tax effects of changing exchange rates can impact the tax expense, and thus the cash flows