Question

Reno, Inc., is considering a project to establish a plant for producing and selling consumer goods
in an under developed country. Assume that the host country’s economy is very dependent on
oil prices, the local currency of the country is very volatile, governance standards are quite
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compromised with a high pedigree of unfair practices and the sovereign or country risk is
considered to be high. It is known that the host country’s economic conditions are un-related to
U.S. economy and the global economy other than material changes that relate and/or emanate
in external environment due to oil price changes.
Required:
a) Should the required rate of return (and therefore the risk premium) on the project be
higher or lower than that of other alternative projects in the i) United States; ii) any
other G-7 country; iii) Pakistan? Explain with cogent reasons.
b) Assume that the required rate of return is 20% in the first year of operations and
increases by 2% every year for 5-years. Based on financial projections and estimated
cash flows, return on equity (ROE) is expected to be in the ball park of 18% in Year-1,
whereas moving forward in Year-2 through Year-5 it is expected to remain in range of
30% per annum. Based on these numbers, would you recommend that Reno should
move ahead with this new investment? Why or why not? Explain with cogent reasons.

Answer 1

First let's summarize the macroeconomic condition of the underdeveloped economy.

a. highly depended on oil prices, currency volatility and low governance standards - Material risk as oil pricing power is in the hands of other nations, therefore this country should have financial problems

b. indulges in unfair practices and high country risk.

c. high amount of idiosyntratic risk by not connecting to global economy.

A. Based on the above factors required rate of return should be higher than US as this country has so many additonal risks therefore to account for adequate returns required rate of return should be more than US.

Any other G-7 country are not having the risks stated for this country and no G7 country is underdeveloped therefore it should have high required rate of return than G7 country.

Comparing it with Pakistan, this country seems to have more risks than Pakistan too. As Pakistan has idiosyntratic risks, unfair practices and high country risks but they have good financial support from China, stable currency value, stable government. Therfore based on above points I would like to charge more rate of return than Pakistan too.

B.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	CAGR
Required Rate of return	20%	22%	24%	26%	28%	24%
ROE	18%	30%	30%	30%	30%	27%

As ROE of entire duration is higher than required rate of return. It is advisable to invest in this project.

CAGR (Compounded Annula Growth Rate) = (20%*22%*24%*26%*28%)^0.2 = 24%

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