This is a capital budgeting paper using FedEx as an example. The project is located in Canada, so this adds lessons on interest rate parity to calculate the value of the project in US dollars, by estimating the future exchange rates. In addition, the cash flows are subject to adjustment for the tax benefits of depreciation and for the company's internal discount rate.
FedEx
Some assumptions need to be made to help to determine the after-tax cash flow for FedEx. First, the figures in the real world are only translated into U.S. dollars -- they are kept in Canadian dollars at FedEx Canada. Thus, that is translation, not a cash flow. It is also worth mentioning that the tax is also in Canadian dollars for FedEx Canada, being a company registered in Canada. The tax rate for Canada is not noted so the assumption used is that a normal tax rate in recent years will be used. The normal provision for income taxes for FedEx Corporation is 37%, so that rate will be used.
The salvage value is posted as revenue. This is because by the end of year six, when the equipment is sold, it has been fully depreciated. At that point, revenue generated from the sale of these assets is counted as revenue, rather than a capital transaction, because the entire cost of these assets has already been taken from book value. This revenue, therefore, is taxed, since it cannot be written down.
The rates on U.S. treasury bonds for the next six years are as follows: 0.861%, 1.315%, 1.833%, 2.244%, 2.623%, 2.827%. For Canadian bonds, 1.18%, 1.15%, 1.22%, 1.34%, 1.36%, 1.65%. The spot exchange rate is that $1USD = CAD .97844
Thus, the expected exchange rates, given the assumption of interest rate parity, are as follows:
Expected Exchange Rates
Annualized
Annualized
Spot
1.02143
USD Rate
CAD
1
1.019015
0.00861
0.011
2
1.022995
0.01315
0.0116
3
1.027413
0.01833
0.0124
4
1.030542
0.02244
0.0134
5
1.03375
0.02623
0.014
6
1.033257
0.02827
0.0165
These figures that be used to convert the CAD cash flows into future USD.
According to the FedEx 2010 Annual Report (p.49), the company's discount rate for internal usage is 12%, so that is the discount rate used in this example.
The prospect of higher inflation in the future has already been accounted for. The discount rate factors in future inflation, as does the interest rates that are used in interest rate parity. Thus, the net present value of the project already reflects expectations for future inflation in both the U.S. And in Canada. No further accounting of inflation expectations should be done. The basic figures initially presented of course do not factor in inflation, which is why I have added the discount rate and the expected future interest rates. Those are essential in accounting for the effects of inflation.
Memo:
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