Case Report 1: Groupe Ariele S.A.
Introduction
Groupe Ariele S.A. is considering a complete overhaul of their company process. The Mexican investment called for the purchase and installation of new automated machinery to recycle and manufacture toner- and print cartridges. For this case, it was necessary to analyze the net present value of the project. Groupe Ariel S.A. would only go forward with the project if the NPV is positive. A distinction was also made between the Euro and Mexican peso in order to determine which currency Groupe Ariele should choose to go with in order to maximize their return. Last, we also considered the possible inflation and risk that are undoubtedly involved in a project of this magnitude.
Question 1: Compute the NPV of Ariel-Mexico's recycling equipment in pesos by
discounting incremental peso cash flows at a peso discount rate and translate this into Euro.
Groupe Ariele is willing to invest in a new company process, going from a manual process to an automatic process. To assess the impact of this whole project, the cash flows were calculated to determine in what way this project would impact their financials.
We calculated the Net Present Value of this project using the NPV function in Excel (Exhibit 1). First of all, we calculated the difference in operating costs by subtracting the cost of the old equipment by the cost of the new equipment. Afterwards the depreciation old the equipment and new equipment were added to the formula. Lastly, the tax rate and shield were added to compute the incremental cash flows which in this case are positive because the reduced cost equals the cash flows. Afterwards, these incremental cash flows were added to the NPV function in Excel
using a 12.19% discount rate (which was calculated using iMXN=
(
1+πMexico 1+πFrance
)
(
1+iAriel
)
−1 ) to arrive at the Project Net Present Value in Mexican pesos (MXN 1,478,998). Last, this number was divided by the spot exchange rate of MXN15.99/EUR to arrive at €92,495.18 as the project NPV in euro.Compute the NPV in Euros by translating the project's future peso cash flows into Euros at expected future spot exchange rates. Assume that inflation rates are expected to be 7% in Mexico and 3% in France.
As mentioned before, the NPV was calculated using the Project NPV and dividing this by the spot exchange rate. Another method that can be used is to use the expected future spot exchange rates. For this method, a derivation of the PPP equation was used to compute the projected future
exchange rates ( EUR MXN /¿ EUR MXN /¿ St¿=
(
1+πMexico 1+πFrance)
t S0¿ E¿. The present value of the net cash flows were calculated
in euros and afterwards the net investment was subtracted. The value of the Project NPV was equal to the one computed using the spot exchange rate because of the presumption of the PPP equation, €92,495.18.
Compare the two sets of calculations and the corresponding NPVs. How and why do they differ? Which approach should Ariel's financial analyst use?
In this case, the NPV’s that were calculated are the exact same number. Basically, if purchasing power parity holds for the entire period of the investment there will be no difference between either of the approaches. If the PPP assumption would not exist and interest rates stay the same, depending on whether the euro depreciates or appreciates against the peso, the euro value NPV of the project would be greater or respectively less than the peso value.
Suppose Mexican inflation is projected at 3% instead of 7% per year (assume French inflation remains 3%). How does this affect the NPV calculations?
Groupe Ariele S.A. would like to know what happens when the Mexican inflation is projected at 3% instead of 7% per year. For this question, the incremental cost savings were calculated at the lower Mexican inflation rate of 3% (materials, direct labor and overhead) for both processes.
Afterwards, a new discount rate was calculated using the iMXN=
(
1+πMexico
1+πFrance
)
(
1+iAriel)
−1 )formula, which made the discount rate arrive at 8%. The NPV of the project were then calculated in Mexican Pesos (MXN 1,770,028.70). Using the spot exchange rate of MXN15.99/EUR this ended up being €110,695.98. The peso/euro exchanges rates will stay the same if PPP holds and inflation rates stay the same.
Suppose Groupe Ariel expects a significant real depreciation of the peso against the Euro. How should its financial analyst incorporate such an expectation into his NPV analysis? What is the peso depreciation effect on the NPVs under each of the two approaches?
Groupe Ariel seems to be expecting a real depreciation of the peso against the Euro, and needs to account for this. For this case, one would have to know what the peso deprecation effect on the NPV’s will be for questions 1 and 2. To calculate the answer, the new cash flows were calculated based on an exchange rate of MXN22.00/EUR in 2009 and MXN25.00/EUR for years 2010-2018.
If the peso realistically depreciates against the Euro in this way, the resulting NPV in euros will be reduced to €-690.26. And as mentioned at the start of this case report, if an NPV is negative, one should not go forward with a project.
Should Groupe Ariel approve the equipment purchase? How should Groupe Ariel finance the project? In pesos or in Euros? Will this affect your conclusions on whether Groupe Ariel should approve the project?
The question is whether Groupe Ariel S.A. should approve this project and purchase the
equipment. To assess this problem, the NPV’s of every section were analyezed. In almost every case the NPVs were positive, which means that Groupe Ariel should go ahead with the project. However, if Groupe Ariel was expecting depreciation of the peso against the euro, the NPV turned negative. If that would be the case, the project should not be undertaken. However, we believe that financing the project is the right way to go because the risk of possible depreciation can be offset by using a hedging option.
We now have to decide whether to finance the project in pesos or euros. To assess this issue, we have taken a look at the volatility of the peso against the euro in the following graph. This shows the value of the peso against the euro for the last 3 years.
We also considered the current economic situation in the area that these currencies are used. Even though both Mexico and the EU are not excelling, the EU is trailing. They currently have issues with refugees, went through a lot of hardship with Greece and are still in doubt how to ensure economic prosperity. We believe the euro might keep losing value as more and more countries are given bailout packages and countries are considering leaving the EU. For that reason, we believe it might be more interesting to finance the project in pesos.
In conclusion, we believe Groupe Ariel S.A. should go ahead and finance the project because of the positive net present values that we established and because the risk of depreciation can be hedged. The currency we decided Groupe Ariel S.A. should go with is the euro because of the current economic situation in Europe and the fact that the value of the euro might go down.
