Download Nicholas Brunner FIN 425 Dr. Margetis Capital Budgeting Project

Nicholas Brunner
FIN 425
Dr. Margetis
Capital Budgeting Project
Before OSI Restaurant Partners’ implement their plan to expand operations
into Munich and Berlin, Germany, a proper analysis of the profitability of the
expansion must be conducted. OSI currently utilizes the net present value as the
determinant for profitability of a proposed project. Given the international
exposure, the net present value must be conducted within the parent prospective
using the proper parity condition. OSI must also compare the parent perspective to
the project perspective to account for other alternatives within Germany and decide
if it is necessary to hedge the foreign exchange risk. Ultimately, this analysis will
determine the profitability of the expansion, allow OSI to understand the most
sensitive factors of the expansion, and decide if they should implement the
expansion.
In order to account for the foreign exchange risk that OSI will be exposed to,
the net present value shall be conducted within the parent prospective. In order to
project the change in the exchange rate over the ten year time period of the
expansion, parity conditions must be utilized. Within this analysis the interest rate
parity, relative purchasing power parity and the random walk condition were used.
The random walk projection implies that the change in the exchange rate
between two currencies is independent of past changes and is equally likely to
increase or decrease. Thus the probability of appreciation or depreciation of a
currency is equal. The random walk condition best describes the change in the
exchange rate within a short time period of one year or less. Forecasts longer than
one year are better projected by the parity conditions. Due to OSI’s forecast horizon
of ten years, the random walk condition is not the best predictor of the change in the
exchange rate.
The interest rate parity states that the forward premium or discount on a
currency reflects the differential between the nominal interest rates between the
two countries. The country with the lower nominal interest rate should trade at a
forward premium compared to the currency of a country with a higher rate. In order
for the interest rate parity to hold, both currencies must be actively traded within
the spot market, forward market and the Eurocurrency market. If these conditions
are meet, the interest rate parity will always hold for market makers within the
bounds of transaction costs. The interest rate parity condition best forecasts the
change in the exchange rate within one to two years. Due to OSI’s time horizon of
ten years, the interest rate parity will not be used.
The relative purchasing power parity states that the expected future spot
rate is determined by the inflation differential between the two currencies. Thus
currencies with high inflation should depreciate relative to currencies with low
inflation. Since expected inflation is not a traded contract, the parity condition will
not always hold. Yet the parity condition is the best long-term forecasting tool since
over the long run, inflation differentials eventually prevail. Due to OSI’s ten-year
time horizon, the relative purchasing power parity is the best forecaster for the
change in the exchange rate.
OSI must account for the foreign exchange rate risk they are exposed to
through this expansion. The project perspective allows OSI to properly evaluate this
risk. Through the use of the relative purchasing power parity, OSI can forecast the
change in the exchange rate between the euro and the US dollar. Using the
forecasted future spot rates, all cash flows are converted into the domestic currency
(US dollars) and are discounted by the applicable US interest rate of twenty five
percent. The resulting net present value is denominated in US dollars, allowing OSI
to forecast the profitability of the expansion accounting for foreign exchange risk.
The net present value of the expansion within the parent perspective is
$2,715,820.29. This means that the expansion is equivalent to OSI receiving
$2,715,820.29 today. The probability of a positive net present value is 72.238% with
a range width of $13,443,168.47. The range width is the difference between the
maximum ($11,608,749.76) and minimum (-$1,834,418.70) values and represents
the riskiness of the expansion. The expansion has a median net present value of
$1,953,720.94, a mean net present value of $1,894,328.05 and a base case net
present value of $2,715,820.29. In summation, the OSI’s expansion within the parent
perspective has a positive net present value of $2,715,820.29, a certainty level of
72.238% and a range width of $13,443,168.47.
In order to compare OSI’s expected profitability of the expansion to local
alternatives within Germany the project perspective was utilized. The project
perspective does not account for foreign exchange risk. When calculating the net
present value within the project perspective all of the cash flows are denominated in
the foreign currency (euro) and discounted by the foreign nominal discount rate of
thirty percent. The resulting net present value is denominated in the foreign
currency and is then converted into the domestic currency using the current spot
rate of 1.29985 $/€. Although this perspective does not include foreign exchange risk,
it does have relevance within the decision making of OSI. The project perspective
allows OSI to compare the net present value of the expansion other alternatives
within Germany. This allows OSI to evaluate their opportunity costs within the
foreign nation thus allowing OSI to maximize the return on their investment.
The net present value of the expansion within the project perspective is
$1,911,337.85. This means that the expansion is equivalent to OSI receiving
$1,911,337.85 today. The probability of a positive net present value is 68.94% with
a range width of $11,403,526.71. The range width is the difference between the
maximum ($9,440,775.10) and minimum (-$1,962,751.61) values and represents
the riskiness of the expansion. The expansion has a median net present value of
$1,273,034.78, a mean net present value of $1,265,224.55 and a base case net
present value of $1,911,337.85. In summation, the OSI’s expansion within the
project perspective has a positive net present value of $1,911,337.85, a certainty
level of 68.94% and a range width of $11,403,526.71.
It is necessary to compare the statistics of the parent and project perspective
in order to assess the foreign exchange risk. The net present value of the project
perspective was less than the net present value of the parent perspective, implying
the change in the exchange rate will move in the favor of OSI. In this case, OSI is
projected to benefit from the foreign exchange risk. As expected due to the higher
return through the parent perspective, the range width is higher in the parent
perspective. The higher range width implies that the risk is greater. Although the
risk is higher, OSI does not need to hedge their foreign exchange risk due to the
expected favorable change. In addition to a higher risk and return, the parent
perspective has a higher certainty level, maximum, mean and median.
In order to better understand the risk of the expansion, a sensitivity analysis
must be conducted. The top risks to the profitability of the expansion were first year
revenue in Munich, first year revenue in Berlin, food costs in Berlin and food costs in
Munich. All of these factors are affected by management’s actions. Thus a proper
plan must be implemented to limit the risk to the project. In order to increase the
first year revenue within Munich and Berlin, management should conduct effective
marketing and create a consumer loyalty program. Effective marketing will increase
the demand for the restaurant while the consumer loyalty program will provide
incentives for consumers to return to the restaurant. The management should
implement both strategies within Munich and Berlin but focus on Munich due to
higher sensitivity.
Due to the risk of food costs within Berlin and Munich, management must
take additional steps to control the risk. Management should track their food costs
and conduct daily inventory checks to create accurate food usage projections.
Proper projections will prevent management from ordering too much food,
resulting in a waste. In addition, management must properly train their employees
in the kitchen on portion control and minimizing food waste. Portion control will set
uniform standards and prevent employees from over serving. These steps will help
reduce the risk of a negative return on the expansion.
Ultimately, OSI Restaurant Partners should implement their plan to open two
restaurants within Germany. The net present values of the expansion within both
the project and parent perspective were positive. Thus the expansion will have a
positive return with and without foreign exchange risk. The net present value within
the parent perspective was higher than the project perspective, implying a favorable
change in the exchange rate. Due to the favorable change between the euro and the
dollar, hedging the foreign exchange risk is not mandatory. In addition, management
should take proper steps to reduce the risk of a loss through effective marketing, a
loyalty program and proper food usage constraints.