Question

You are considering a project in Bolivia that would generate 3 million dollars in cash flows per year going forever. The cost of the project is 10 million dollars. The discount rate for the project is 15%. You believe that there is some probability of expropriation prior to the 3rd year (after the 2nd cash flow). Which of the following statements is most correct?

a. This is a good project if the probability of expropriation is larger than.33.
b. This is a good project if the probability of expropriation is smaller than.33.
c. This is a good project if the probability of expropriation is smaller than .
d. This is a good project if the probability of expropriation is smaller than .66.

Answer 1

b. This is a good project if the probability of expropriation is smaller than .33.

Explanation:

a) Data and Calculations:

Cash inflows per year going forever = $3 million

Cost of project = $10 million

Discount rate for the project = 15%

The present of a perpetuity = Cash inflow/Discount rate

= $3/0.15 million

= $20 million

NPV = $10 million ($20 - $10 million)

b) The probability of expropriation indicates that the government of Bolivia may likely take over the project after the initial investment had been made. This will cause the investor to lose her investments. If the probability of the expropriation taking place is equal to 0.33, the investor may recover the cost of investment without making any profit in three years' time. But if the probability of expropriation happening is less than 0.33, the investor could recover enough to cover the investment cost.