Solve the following problem:
How Country Risk Affects NPV
Hoosier, Inc., is planning a project in the United Kingdom. It would lease space for 1 year in a shopping mall to sell expensive clothes manufactured in the United States. The project would end in 1 year, when all earnings would be remitted to Hoosier, Inc. Assume that no additional corporate taxes are incurred beyond those imposed by the British government. 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 initial outlay required by the parent to fill the store with clothes is $200,000. The pretax earnings are expected to be £300,000 at the end of 1 year. The British pound is expected to be worth $1.60 at the end of 1 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 ¼ 30 percent), which would cause the expected pretax 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 ¼ 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.