Question

You are considering investing in a project in Mexico. The project will be a 2 year project, has an initial cost of 100K USD, and expected after tax profit of 1 million MXP per year. You expect the MXP to be valued at 0.12 USD/MXP.

There are two major risks that you think have the potential to significantly affect project performance, which you assume are independent:

* You think with probability of 0.16 that the MXP will depreciate to 0.1 USD/MXP.
* You also think that with probability of 0.24 the Mexican economy will weaken substantially, in which case the project's after tax annual cash flow will be only 600K MXP.

Your required return on the project is 18%. What is the expected value of the NPV of this project, as measured in USD?

Answer 1

Solution :

In this problem, we are investing in USD and investment is $100,000.

Profit is in MXP and it is 1,000,000 in a normal case

Current exchange rate = 0.12 USD/ MXP, there is 0.16 probability that exchange rate will go to 0.10 USD/ MXP and (1-0.16) = 0.84 probability that exchange rate will remain same.

So taking into consideration of the probability effective rate = 0.16 * 0.10 + 0.84 * 0.12 = 0.1168 USD / MXP

There is 0.24 probability of ecomomy will weaken and profit will be 600,000 MXP and (1-0.24) = 0.76 probability of earning 1 million MXP

So effective after tax profit = 0.24* 600,000 + 0.76 * 1,000,000 = 904,000

Required rate of return is = 18%

Year 0 Cash flow = -100,000 USD

Year 1 Cash flow = 904,000 MXP , Exchange rate = 0.1168 USD/MXP

Cash flow in USD = 904,000 * 0.1168 = 105587.2 Discounted Cash flow =105587.2 / (1+0.18) = 89480.68

Year 2 Cash flow = 904,000 MXP , Exchange rate = 0.1168 USD/MXP

Cash flow in USD = 904,000 * 0.1168 = 105587.2 Discounted Cash flow =105587.2 / (1+0.18)^2 = 75831.08

NPV = Year 0 CF + Discounted Year 1 CF +  Discounted Year 2 CF

= -100,000 + 89480.68 +75831.08 = 65,311.76 USD