Question

Kansas Co. wants to invest in a project in China. It would require an initial investment of 5,000,000 yuan. It is expected to generate cash flows of 7,000,000 yuan at the end of one year. The spot rate of the yuan is $.12, and Kansas thinks this exchange rate is the best forecast of the future. However, there are 2 forms of country risk.

First, there is a 50% chance that the Chinese government will require that the yuan cash flows earned by Kansas at the end of one year be reinvested in China for TWO year before it can be remitted (so that cash would not be remitted until 3 years from today). In this case, Kansas would earn 8% after taxes on a bank deposit in China during that second year.

Second, there is a 40% chance that the Chinese government will impose a special remittance tax of 500,000 yuan at the time that Kansas Co. remits cash flows earned in China back to the U.S.

The two forms of country risk are independent. The required rate of return on this project is 20%. There is no salvage value. What is the expected value of the project’s net present value?

Answer 1

There are 2 forms of country risks, but there are 3 scenarios for Kansas & Co. ltd

1. 50% chance : Cash flow Invested for 2 years before remitting

2. 40% chance : Cash flow to be taxed with 500,000 yuan before remitting

3. 10% chance : Cash flow of 7,000,000 yuan can be remitted in Year 1

Scenario 1 :

7,000,000 yuan are reinvested at 8% for 2 years (after year 1)

The value of this investment after 2 years

= 7,000,000 x 1.08^2

= 7000000 x 1.1664

= 8,164,800

This would be the value 3 years from now.

The PV of this investment at 20% required return

= 8164800 / (1+20%)^3

= 8164800 x 0.5787

= 4,725,000

NPV for scenario 1

= PV of Cashflow - Investments

= 4,725,000 - 5,000,000

= - 275,000

2. 40% chance : Cash flow to be taxed with 500,000 yuan before remitting

Cash flow in Year = 7,000,000

Taxation = 500,000

Net Cash flow available for remitance = 7,000,000 - 500,000

=6,500,000

The PV of Net cash flow available after a year

= 6,500,000 / (1+20%)^1

= 5,416,666.67

NPV = 5,416,666.67 - 5,000,000

= 416,666.67

3.10% chance : Cash flow of 7,000,000 yuan can be remitted in Year 1

PV of 7,000,000 received next year

= 7,000,000 /(1+20%)^1

= 5,833,333.33

NPV = 5,833,333.33 - 5,000,000

= 833,333.34

Expected Value of Projects NPV

= 50% x -275000 + 40% x 416,666.67 + 10% x 833,333.34

= -137,500 + 166,667 + 83,333

= 112,500