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ACCA Strategic Professional · Advanced Financial Management · International investment and financing decisions

A UK company is appraising a project in Country X. Project cash flows are forecast in X-dollars (X$). Expected inflation is 8% a year in Country X and 2% a year in the UK. The UK company's sterling discount rate for the project is 10%. Using purchasing power parity, what is the equivalent discount rate (to the nearest 0.1%) to use for X$ cash flows?

The X$ discount rate is about 16.5%. Multiply one plus the sterling rate by the ratio of one plus Country X inflation to one plus UK inflation, giving 1.10 x 1.08/1.02 = 1.1647, so the rate is 16.5%. Cash flows in a higher inflation currency need a higher rate.

  1. A16.5%Correct
  2. B18.0%
  3. C12.0%
  4. D10.0%

Explanation

Using the Fisher-type relationship, the X$ rate = 1.10 x (1.08/1.02) - 1 = 1.10 x 1.05882 - 1 = 1.16471 - 1 = 16.5%. Simply adding the inflation differential (6%) to 10% gives 16%, and adding total inflation of 8% gives 18%, which ignores compounding or the UK inflation base. Using 10% is wrong because the cash flows are in a currency with higher inflation.

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