Cash flows for a project over 3 years(see below)
Q – How does Maxwell decide which currency to use for payments, & why does it matter whether it chooses one or another? —Each year has a different cash flow, which has a different value for DM and US $. Need assistance with how to compare project bids to make a proper bid for a 3rd bid. Show formulas how to work this process please.
Maxwell Engineering Case details
The result of a bid submitted to the Mexican government’s agency in charge of the rural electrification project had been most disappointing. On November 30, 1984, John Vink, manager of Power Systems at Maxwell, was notified by the Mexican government that Maxwell had been underbid by the Swiss German Consortium of Brown-Boveri & Siemens (BB-S). Maxwell had entered the bidding for the construction of 5 high-voltage units near Guadalajara, Mexico’s thirteenth largest industrial center.
The bid submitted by Maxwell in March 1984 totaled $ 63 million to be paid in 3 equal yearly installments due on the f December 1, 1985, 1986 & 1987, with installation to be completed in the last six months of 1985.
Attached to the reply from the Mexican government was a photocopy of the Brown-Boveri & Siemens bid which was virtually identical from the standpoint of technical specification, but which differed in the terms of payment.
The bid by BB-S offered the equivalent of $ 56 million, denominated in Deutsche Marks at a rate of DM 3.14/$. The payment schedule was identical to Maxwell’s, but the bid required payment in three equal installments of Deutsche Marks.
A second round of bidding was to be held on December 10, and if Maxwell wanted to stay in the race, the bid had to be sent in today, December 1, 1984 in order to meet this deadline. John Vink was concerned that the strong dollar had just about closed his export market. John knew that in spite of his position with the firm, his background as a civil engineer did not equip him with the creative financial skills that could close the seemingly unbridgeable gap between the two bids. Fortunately, John felt that he could depend on his newly hired assistant holding an MBA degree to help him with this problem.
Hint – Has 3 cash flows, 3-year project. Do not just discount the cashflows (7:40) time. Treat as 3 separate cases. Hedge each cash flow separately. Hint 2 – Fwd premium and fwd discount matter. Little mistake is significant error. Do the case from a DM and a dollar. Note: the “building blocks” of a forward contract consist of two loans: simultaneous borrowing in one currency and investing the proceeds in a second currency.
Spot rate on Dec 1, 1984: DM 3.10/$.
Euro deposit rates (in % p.a.) per Dec 1, 1984:
US $ DM
1 year 12.00 5.50
2 years 12.50 5.75
3 years 13.00 6.00