Integrating Country Risk and Capital Budgeting Tovar Co. is a U.S. firm that has been asked to provide consulting services to help Grecia Co. (in Greece) improve its performance. Tovar would need to spend $300,000 today on expenses related to this project. In one year, Tovar will receive payment from Grecia, which will be tied to Grecia’s performance during the year. There is uncertainty about Grecia’s performance and about Grecia’s tendency for corruption.
Tovar expects that it will receive 400,000 euros if Grecia achieves strong performance following the consulting job. However, two forms of country risk are of concern to Tovar. First, there is an 80 percent chance that Grecia will achieve strong performance. In other words, there is a 20 percent chance that Grecia will perform poorly, in which case Tovar will receive a payment of only 200,000 euros.
Second, while there is a 90 percent chance that Grecia will make its payment to Tovar, there is a 10 percent chance that Grecia will become corrupt. In this case, Grecia will not submit any payment to Tovar.
Assume that the outcome of Grecia’s performance is independent of whether Grecia becomes corrupt. The prevailing spot rate of the euro is $1.30, but Tovar expects that the euro will depreciate by 10 percent in one year, regardless of Grecia’s performance or whether it is corrupt.
Tovar’s cost of capital is 26 percent. Determine the expected value of the project’s net present value. Determine the probability that the project’s NPV will be negative.
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