Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Central Antarctic Republic. Payment of $250,000 will be made one year hence after the shipment arrives by snow train. Unfortunately there is a good chance of a coup d’état, in which case the new government will not pay. Mom and Pop’s controller therefore decides to discount the payment at 40 percent, rather than at the company’s 12 percent cost of capital.

a. What’s wrong with using a 40 percent rate to offset political risk?

b. How much is the $250,000 payment really worth if the odds of a coup d’état are 25 percent?