16 How country risk affects NPV. Hoosier Ltd is planning a project in the United States. It would lease space for one year in a shopping mall to sell expensive clothes manufactured in the United Kingdom.

The project would end in one year, when all earnings would be remitted to Hoosier Ltd. Assume that no additional corporate taxes are incurred beyond those imposed by the UK government. Since Hoosier Ltd would rent space, it would not have any long-term assets in the United States and expects the salvage (terminal) value of the project to be about zero.
Assume that the project’s required rate of return is 18%. Also assume that the initial outlay required by the parent to fill the store with clothes is £200 000. The pretax foreign earnings are expected to be $300 000 at the end of one year. The British pound is expected to be worth $1.60 at the end of one year, when the after-tax earnings are converted to pounds and remitted to the United Kingdom. The following forms of country risk must be considered:
l The US economy may weaken (probability ¼
30%), which would cause the expected pretax earnings to be $200 000.
l The US corporate tax rate on income earned by British firms may increase by 25% (probability ¼
20%).
These two forms of country risk are independent.
Calculate the expected value of the project’s net present value (NPV) and determine the probability that the project will have a negative NPV.