Question

How Country Risk Affects NPV. Hoosier, Inc., is planning a project in the United Kingdom. It would lease space for one year in a shopping mall to sell expensive clothes manufactured in the United States. The project would end in one year, whenall earnings would be remitted to Hoosier, Inc. Assume that no additional corporate taxes are in- curred beyond those imposed by the British gov- ernment. Since Hoosier, Inc., would rent space, it would not have any long-term assets in the United Kingdom and expects the salvage (terminal) value of the project to be about zero.Assume that the project’s required rate of return is 18 percent. Also assume that the ini- tial outlay required by the parent to fill the storewith clothes is $200,000. The pretax earnings are expected to be £300,000 at the end of one year. The British pound is expected to be worth $1.60 at the end of one year, when the after-tax earnings are converted to dollars and remitted to the United States. The following forms of country risk must be considered:• The British economy may weaken (probability = 30 percent), which would cause the expected pre- tax earnings to be £200,000.• The British corporate tax rate on income earned by U.S. firms may increase from 40 to 50 percent (probability = 20 percent).These two forms of country risk are independent. Calculate the expected value of the project’s net present value (NPV ) and determine the probability that the project will have a negative NPV.

Answer 1

Answer:

NPV = $11,525.6

Probability the project has negative NPV: 30%

Explanation:

1. When there is no risk:

It is given that the initial British corporate tax rate on income earned by US firms is 40%.

The initial investment: $200,000

The cash flow of Hoosier can be described as following:

+) The addition to the cash flow includes:

• Pretax earnings: £300,000

+) The subtraction to the cash flow includes:

• Tax on income (40%): £300,000 x 40% = £120,000

=> The cash flow = 300,000 - 120,000 = £180,000 = 180,000 x $1,6 = $288,000

=> The Present value of the project after one year is:

PV = Cash flow/ [(1 + required rate of return)^ 1 year]

= 288,000/ (1+0.18) = $244,068

=> The Net Project Value is:

NPV1 = ∑PV - Initial investment = 244,068 - 200,000 = $44,068

2. Case 2: The British economy may weaken

The initial British corporate tax rate on income earned by US firms is 40%.

The initial investment: $200,000

The cash flow of Hoosier can be described as following:

+) The addition to the cash flow includes:

• Pretax earnings: £200,000

+) The subtraction to the cash flow includes:

• Tax on income (40%): £200,000 x 40% = £80,000

=> The cash flow = 200,000 - 80,000 = £120,000 = 120,000 x $1,6 = $192,000

=> The Present value of the project after one year is:

PV = Cash flow/ [(1 + required rate of return)^ 1 year]

= 192,000/ (1+0.18) = $162,712

=> The Net Project Value is:

NPV 2= ∑PV - Initial investment = 162,712 - 200,000 = -$37,288

3. Case 3: The British corporate tax rate on income earned by U.S. firms may increase from 40 to 50 percent

British corporate tax rate on income earned by US firms is 50%.

The initial investment: $200,000

The cash flow of Hoosier can be described as following:

+) The addition to the cash flow includes:

• Pretax earnings: £300,000

+) The subtraction to the cash flow includes:

• Tax on income (50%): £300,000 x 50% = £150,000

=> The cash flow = 300,000 - 150,000 = £150,000 = 150,000 x $1,6 = $240,000

=> The Present value of the project after one year is:

PV = Cash flow/ [(1 + required rate of return)^ 1 year]

=  240,000/ (1+0.18) = $203,390

=> The Net Project Value is:

NPV3= ∑PV - Initial investment = 203,390 - 200,000 = $3,390

The probability of the case there is no risk = 100% - probability of Case 2 - probability of case 3 = 100% - 30% - 20% = 50%

The expected value of the project’s net present value is:

NPV = probability Case 1 x NPV1 + probability Case 2 x NPV2 + probabilityCase 3 x NPV3

= 50% x 44,068 + 30% x (-37,288) + 20% x 3,390= $11,525.6

As only the NPV of case 2 are negative, so that the probability that the project will have a negative NPV = probability case 2 = 30%