Question

(Country Risk and Capital Investment) Blueberry Farm Inc. (U.S. firm) is planning a project in Japan. The project would end in one year, when all earnings would be remitted to Blueberry. Assume that no additional corporate taxes are incurred beyond those imposed by the Japanese government. Since Blueberry would rent space, it would not have any long-term assets in Japan, and expects the salvage (terminal) value of the project to be about zero. Assume that the project’s required rate of return is 25 percent. Also assume that the initial outlay is $250,000. The pretax earnings are expected to the ¥6,500,000 at the end of one year. The Japanese yen is expected to be worth $0.009 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, which are independent, must be considered: * The Japanese economy may weaken (probability = 55%), which would cause the expected pretax earnings to be €3,500,000. * The Japanese corporate tax rate on income earned by U.S. firms may increase from 35 percent to 45 percent (probability = 20 percent).

1A. What is the expected NPV? What is the probability that that the NPV would be negative? You will have to provide your calculation steps.

1B. Should Blueberry undertake this investment project? Please justify your solution.

Answer 1

Expected Pre tax earnings =6,500,000 *0.45 + 3,500,000*0.55 = 4,850,000 Yen [ 45% Probability of not weakening and 55%probability of weakening]

Expected Pre tax earnings = 4,850,000 Yen

Expected after tax earnings = 4,850,000*(1-0.35) *0.8 + 4,850,000*(1-0.45)*0.2 [We expect 20% (0.2) probability, that tax will be 45% and 80% probability tax will be 35%]

Expected after tax earnings = 3,055,500 Yen

PV of the expected after tax earnings = 3,055,500/1.25 = 2,444,440 Yen

PV of the expected after tax earnings in USD =2,444,440 *0.009 = 21,999.6 = 22,000 USD

1A.NPV = 22,000-250,000 = -228,000 USD(negative)

Probability that NPV will be negative = 100% becuase of the exchnage rate. Even if we assume the company does get the full 6,500,000 Yesn, that would make it only 58,500 USD which would be a pure negative NPV

1B. The Company should not take this project since it has negative NPV