Political Risks Question 1 1. Your firm is considering launching its new product, the sentient Butter Robot C137, in the far off lands of The Citadel. The Butter Robots raison dtre is to serve sticks of butter to humans at the dining table. You estimate that the project will provide the following annual free cash flows (FCFs):

Year 1 Year 2 Year 3 Year4

FCF $40 M $90 M $150 M $175 M

The project would require an initial up-front investment of $74.00 million. In addition, you estimate that the appropriate cost of capital for butter robot projects of this risk class is 25.0% per annum.

a. Given the above, what is the NPV of the project? Would you accept the project?

b. Due to the recent collision of The Citadel with a Galactic Federation prison, The Citadel is currently experiencing a severe fiscal crisis and the ruling council has threatened to nationalize foreign-owned assets. You now estimate that there is a 30% chance in any given year that your project assets will be expropriated without compensation. The cost of capital of 25.0% p.a. used in the previous question does not factor in any such risk of expropriation. What is the NPV of your project now? Would you accept the project?

c. Your Federation Insurance Bureau contact, Jerry Smith, informs you that your firm can be provided with political risk insurance. This would compensate your firm with todays estimate of the uninsured projects NPV at the end of the year in which your assets were seized. The insurance contract requires payment of its $3.90 million annual fee at the start of each year of coverage. What is the NPV of your project now? Would you insure the project?