Chen Transport, a U.S. based company, is considering expanding its operations in

Question

Chen Transport, a U.S. based company, is considering expanding its operations into a foreign country. The required investment at Time = 0 is $10 million. The firm forecasts total cash inflows of $4 million per year for 2 years, $6 million for the next 2 years, and then a possible terminal value of $8 million. In addition, due to political risk factors, Chen believes that there is a 50% chance that the gross terminal value will be only $2 million and a 50% chance that it will be $8 million. However, the government of the host country will block 20% of all cash flows. Thus, cash flows that can be repatriated are 80% of those projected. Chen's cost of capital is 15%, but it adds one percentage point to all foreign projects to account for exchange rate risk. Under these conditions, what is the project

Explanation / Answer

Chen Transport, a U.S. based company, is considering expanding its operations into a foreign country. The required investment at Time = 0 is $10 million. The firm forecasts total cash inflows of $4 million per year for 2 years, $6 million for the next 2 years, and then a possible terminal value of $8 million. In addition, due to political risk factors, Chen believes that there is a 50% chance that the gross terminal value will be only $2 million and a 50% chance that it will be $8 million. However, the government of the host country will block 20% of all cash flows. Thus, cash flows that can be repatriated are 80% of those projected. Chen's cost of capital is 15%, but it adds one percentage point to all foreign projects to account for exchange rate risk. Under these conditions, what is the project’s NPV?
a. $1.01 million
b. $2.77 million
c. $3.09 million
d. $5.96 million
e. $7.39 million

Expected terminal cash flow (CF5) = 0.5($8) + 0.5($2) = $4 + $1 = $5.

                                   Unrestricted

        Projected     Percent       Repatriable

Year    Cash Flow   Unrestricted   Cash Flows

1        $4          0.80            $3.2

2         4          0.80             3.2

3         6          0.80             4.8

4         6          0.80             4.8

5         5          0.80             4.0

NPV = -$10.0 +3.2/ (1.16)+3.2/ (1.16)^2+4.8 / (1.16)^3+4.8 / (1.16)^4+4 / (1.16)^5+

     = -$10.0 + $2.75862 + $2.37812 + $3.07516 + $2.65100 + $1.90445

    = $2.76735 = $2.77 million.

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