In: Finance
(Country Risk and Capital Investment) Blueberry Farm Inc. (U.S. firm) is planning a project in Japan. The project would end in one year, when all earnings would be remitted to Blueberry. Assume that no additional corporate taxes are incurred beyond those imposed by the Japanese government. Since Blueberry would rent space, it would not have any long-term assets in Japan, and expects the salvage (terminal) value of the project to be about zero. Assume that the project’s required rate of return is 25 percent. Also assume that the initial outlay is $250,000. The pretax earnings are expected to the ¥6,500,000 at the end of one year. The Japanese yen is expected to be worth $0.009 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 Japanese economy may weaken (probability = 55%), which would cause the expected pretax earnings to be €3,500,000. * The Japanese corporate tax rate on income earned by U.S. firms may increase from 35 percent to 45 percent (probability = 20 percent).
1A. What is the expected NPV? What is the probability that that the NPV would be negative? You will have to provide your calculation steps.
1B. Should Blueberry undertake this investment project? Please justify your solution.
Initial Investment = $ 250000
Pretax Earnings in Normal scenario and with Tax rate of 35% = Yen 6500000
After tax cash flows = 6500000 x 65% = yen 4225000
NPV = $ 250000 - (4225000 x 0.009 )/1.25 = ( $ 219580) i.e negative NPV of $ 219580
Scenario of Weak economy with normal tax rate
Pretax Earnings = Yen 3500000
After tax cash flows = Yen 3500000 x 65% = Yen 2275000
NPV = $ 250000 - (2275000 x 0.009 )/1.25 = ( $ 229525) i.e negative NPV of $ 229525
Scenario of Weak economy with increased tax rate
Pretax Earnings = Yen 3500000
After tax cash flows = Yen 3500000 x 55% = Yen 1925000
NPV = $ 250000 - (1925000 x 0.009 )/1.25 = ( $ 232675) i.e negative NPV of $ 232675
Pretax Earnings in Normal scenario and with Tax rate of 45% = Yen 6500000
After tax cash flows = 6500000 x 55% = yen 3575000
NPV = $ 250000 - (3575000 x 0.009 )/1.25 = ( $ 224260) i.e negative NPV of $ 224260
Expected NPV = probability x NPV
therefore Expected NPV = 0.55 x 0.20 x (-232675) + 0.55 x 0.80 x (-229525) + 0.45 x 0.20 x (-224260) + 0.55 x 0.80 x (-219580) = $ - 243384
So, there is 100% probability that NPV will be negative
1B. Blueberry should not undertake the project as the NPV is negative in all of the scenarios