Question

22. Wentworth Co. is planning a project in France. It would lease space for one year in a shopping mall to sell expensive clothes manufactured in the U.S. The project would end in one year, when all earnings would be remitted to Wentworth Co. Assume that no additional corporate taxes are incurred beyond those imposed by the French government. Since Wentworth Co. would rent space, it would not have any long-term assets in France, and expects the salvage (terminal) value of the project to be about zero.   Assume that the project’s required rate of return is 20 percent. Also assume that the initial outlay required by the parent to fill the store with clothes is $300,000. The pretax earnings are expected to the €500,000 at the end of one year. The euro is expected to be worth $1.16 at the end of one year, when the after-tax earnings are converted to dollars and remitted to the United States. The following forms of country risk, which are independent, must be considered: * The French economy may weaken (probability = 35%), which would cause the expected pretax earnings to be €400,000. * The French corporate tax rate on income earned by U.S. firms may increase from 30 percent to 40 percent (probability = 30 percent).        -$16,815        -$18,265        $1,165        $2,375

Continued from Question 22, what is your recommendation to Wentworth Co. regarding the feasibility of this project based on the NPV rule?        Wentworth Co. could undertake the project because the expected NPV is positive.        Wentworth Co. should not undertake the project because the expected NPV is negative.

Continued from Question 22, what is the probability that the NPV would be negative?        10.5%        35%        54.5%        100%

Answer 1

Required return=20%

Initial outlay=$3,00,000

Expected pre tax earnings=5,00,000 euros but if economy weakens, pre-tax earnings will be 4,00,000 euros whose probability is 35%.

Expected pre-tax cash flow=(5,00,000*0.65+4,00,000*0.35) euros=4,65,000 euros

Tax rate=30% but it may increase to 40% whose probability is 30%.

Expected tax rate=30*0.7+40*0.3=33%

Expected post tax earnings=4,65,000(1-0.33) euros = 3,11,550 euros

Expected exchange rate at end of 1 year=$1.16/euro

Expected dollar cash flow=$(3,11,550*1.16)=$3,61,398

PV of expected dollar cash flow=$3,61,398/1.2=$3,01,165

Expected NPV=$(3,01,165-3,00,000)=$1,165

Wentworth Co. could undertake the project because the expected NPV is positive.

Let probability of negative NPV be p. So probability of positive NPV will be 1-p.

NPV will be negative when french economy weakens and corporate tax increases.

Negative NPV=(4,00,000*0.6*1.16)/1.2-3,00,000

=$-68,000

NPV will be positive when french economy does not weaken and corporate tax does not increase.

Negative NPV=(5,00,000*0.7*1.16)/1.2-3,00,000

=$38,333.33

that is 35% probability that NPV will be negative.