Question

Question 1 The US based firm, Boston Co. wants to invest in a project in South Africa. Assume the following information:

• It would require an initial investment of ZAR6 million.

• It is expected to generate cash flows of ZAR8 million at the end of one year.

• The spot rate is ZAR 1 = USD 0.091, and Boston Co. thinks this exchange rate is the best forecast of the future.

• However, there are two forms of country risk which are independent:

a. There is a 30% chance that the South African government will require that the ZAR cash flows earned by Boston Co. at the end of one year be reinvested in South Africa for one year before it can be remitted. In this case, Boston would earn 5% after tax on a bank deposit in South Africa during that second year.

b. There is a 55% chance that the South African government will impose a special remittance tax of ZAR500,000 at the time when Boston Co. remits cash flows earned in South Africa back to the USA.

• The required rate of return on this project is 25%.

• There is no salvage value.

Calculate the project’s expected Net Present Value (NPV).

Answer 1

Initial Investment in USD = ZAR6 million = ZAR 6 million * 0.091 $/ZAR = USD 546000

Cashflows after one year in USD =  ZAR 8 million = ZAR 8 million * 0.091$/ZAR = USD 728000

There are three cases here, Reinvestment requirement (30%) , tax (55%) and no risk (15%)

Case 1)
If reinvestment is required by South African Government for one year (probability 30%)

Cashflows will be reinvested and one will get USD 728000 *1.05 = USD 764400 after two years

NPV (in USD) = -546000 + 764400/1.25^2 = - $56784

Case 2) If tax of ZAR 500000 is imposed (55% probability)

Cashflows after one year = ZAR 7.5 million * 0.091$/ZAR = USD 682500

NPV (in USD) = -546000 + 682500/1.25 = 0

Case 3) No risk occurs (15% probability)

NPV (in USD) = -546000 + 728000/1.25 = $36400

Expected NPV = sum of probability weighted NPVs

=0.3*(-$56784) + 0.55* 0 + 0.15 * $36400

= - $11575.20