Question
ABC is a company located in London which specializes in the production of home appliances. The companys MD has been to Pakistan where she has
ABC is a company located in London which specializes in the production of home appliances. The companys MD has been to Pakistan where she has been discussing a possible joint venture. The joint venture agreement would be for a period of five years. At the end of year 5 the terminal value of ABCs share of the joint venture is currently estimated to be 700,000 (in year 5 prices). Alternatively, if ABC prefers, the Pakistan company will guarantee to buy ABC's share of the venture for 520,000, after any tax liabilities. The Pakistan company has agreed that it would not export to Europe within the next five years.
The tax rate is 20% in Pakistan and 30% in the UK. A bilateral tax agreement exists between Pakistan and the UK. Tax is payable one year in arrears.
ABC's cost of capital is 13%, but because of the risk of operating in ABC, ABC's finance director is proposing to use 17% as the cost of capital for the joint venture.
The risk-free rate in the UK is 1%. The chief executive has estimated the likely volatility of the joint venture project cash flows at a standard deviation of 30%.
Required
Calculate the value of the option to sell the joint venture.
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