Louisville Co. is a U.S. firm considering a project in Austria which it has an initial cash outlay of $7 million. Louisville will accept the project only if it can satisfy its required rate of return of 18 percent. The project would definitely generate 2 million euros in one year from sales to a large corporate customer in Austria. In addition, it also expects to receive 4 million euros in one year from sales to other customers in Austria. Louisville's best guess is that the euro's spot rate will be $1.26 in one year. Today, the spot rate of the euro is $1.40, while the one-year forward rate of the euro is $1.34. If Louisville accepts the project, it would hedge all the receivables resulting from sales to the large corporate customer, and none of the expected receivables due to expected sales to other customers.
a. Estimate the net present value (NPV) of the project.
b. Assume that Louisville considers alternative financing for the project, in which it would use $5 million cash, and the remaining initial outlay would come from borrowing euros. In this case, it would need 1,600,000 euros to repay the loan (principal plus interest) at the end of one year. Assume no tax effects due to this alternative financing. Estimate the NPV of the project under these conditions.
c. Do you think the Louisville's exposure to exchange rate risk due to the project if it uses the alternative financing (explained in part b) is higher, lower, or the same as if it has an initial cash outlay of $7 million (and does not borrow any funds)? Briefly explain.