Problem: A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10 percent devaluation is expected to lower unit costs by $0.30, while a 15 percent devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10 percent or 15 percent is likely, with respective probabilities of .4 and .2 (the probability of no currency change is .4). Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40 percent.
Q1. What will annual dollar cash flows be if no devaluation occurs?
Q2. Given the currency scenario described above, what is the expected value of annual after tax dollar cash flows assuming no repatriation of profits to the United States?