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Canacanada Corporation

Anika Vij, Apurva Kejriwal, Josh Bogomilsky, Justin Xiong, Tyori Wyche
Canacanada Corporation
Anika Vij, Apurva Kejriwal, Josh Bogomilsky, Justin Xiong, Tyori Wyche

When Canacanada is considering installing new equipment in their Mexican subsidiary,


Canexico, the discounted cash flow model and net present value calculations can be performed
in either of the relevant currencies (i.e. Canadian dollars and/or Mexican pesos) because they
will produce the same results either way. Of course, this is only true when the cost of capital
used as the discount rate, the risk-free rate, and the differential inflation values are all internally
consistent with each other.

The hurdle rate of 8.8% for Canadian dollars translates to a 700 basis-point premium over their
Canadian risk-free rate of 1.8%. Using the same premium, the Mexican discount rate would be
700 basis-points above the Mexican risk-free rate of 5.4%, which is equal to 12.4%. These
values for Canada and Mexico are calculated arithmetically, and the equivalent multiplicative
rates would be 8.93% and 12.78%, respectively. See Calculation 1. The difference in risk-free
rates between Canada and Mexico can be attributed entirely to the difference in inflation
between their home currencies, giving a differential inflation of 3.6% arithmetically and 3.54%
multiplicatively. See Calculation 2. The 6% differential inflation estimate given by Jean-Paul is
definitely too high considering the Mexican pesos’ historical trend in inflation being between 3.0-
3.6% from 2012-2017. This inflation value is also not consistent with the risk-free rates in both
countries, which violates the interest-rate parity principle.

The inflation rate used is critical to the NPV calculation for several reasons. Firstly, the costs for
materials, labor, and overhead grow with inflation, so it is important that the inflation value is
accurate to correctly predict costs. Secondly, the MXN/CAD exchange rate over time grows with
inflation, so again, changing the inflation value will change the spot rates used to convert cash
flows between MXN and CAD. Lastly, the difference in the discount rates used for the Mexican
peso and Canadian dollar NPV calculations are directly tied to the difference in risk-free rates
and therefore inflation. If the inflation value used doesn’t match the different discount rates used
and FX rates used, the NPV calculations will not match between currencies, even though they
should. When using the 6% inflation estimate, the NPV using MXN and CAD produce different
values. The NPV calculated using MXN and then converted at the spot rate of 13.08 MXN/CAD
is equal to 57,926.27 CAD. The NPV calculated using CAD is equal to -1,967.53 CAD. This
substantial difference means installing the new equipment if the DCF is in MXN and not
installing the new equipment if the DCF is in CAD. See Tables 1 and 2. When using the 3.54%
inflation estimate, which is in line with the risk-free rates in both countries, the NPV using MXN
and CAD produce exactly the same values. The NPV calculated using MXN and then converted
at the spot rate of 13.08 MXN/CAD and the NPV calculated using CAD are both equal to
13,374.03 CAD. This indicates that it is in fact beneficial for Canacanada to install the new
equipment. See Tables 3 and 4.

APPENDIX
Calculation 1:
WACC(CAD) = 1.018 * 1.07 - 1 = 8.93%
WACC(MXN) = 1.054 * 1.07 - 1 = 12.78%

Calculation 2:
MXN Inflation / CAD Inflation = 1.054 / 1.018 - 1 = 3.54%

Table 1: NPV using MXN and 6% Inflation

Table 2: NPV using CAD and 6% Inflation

Table 3: NPV using MXN and 3.54% Inflation


Table 4: NPV using CAD and 3.54% Inflation