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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.