Question

You are considering a project in Honduras that would generate 1.5 million dollars in cash flows per year going forever. The cost of the project is 8 million dollars. The discount rate for the project is 12%. You believe that there is some probability of expropriation prior to the 4th year (after the 3rd cash flow). Which of the following fully describes when this is a good project?
a. This is a good project if the probability of expropriation is larger than 0.33
b. This is a good project if the probability of expropriation is smaller than 0.33
c. This is a good project if the probability of expropriation is smaller than 0.5
d. This is a good project if the probability of expropriation is smaller than 0.66 7.

Answer 1

Answer:

c. This is a good project if the probability of expropriation is smaller than 0.5

Explanation:

initial outlay = $8,000,000

if no expropriation, NPV = -$8,000,000 + $1,500,000/0.12 = $4,500,000

if the risk of expropriation is 0.33:

NPV = $925,211

if the risk of expropriation is 0.5:

NPV = -$425,265

the breakeven risk = 44.6%