Recent empirical evidence has suggested a strong increase in demand for low-quality basketballs. It is reported that this sudden increase in the demand for basketballs stems from the rise in the popularity of National Basketball Association. Low quality basketballs are typically used as practice basketballs for little league basketball teams and for use in unorganized play. Since the target market consists largely of young adolescents, it is believed that this venture has long-term profitability. As a result, these basketballs are currently marketed to little-league aged basketball players, globally. Many small producers, scattered globally currently serve this perfectly competitive market, where each firm is a price taker. A Mexican -American limited partnership is considering entering this market with a DFI project in Mexico. Barring political instability, Mexico is seriously considered because of its endless supply of low-skill labor, its proximity to the U.S. (the major market where 80% of the demand resides) and the partnerships influence over the public policy through its lobbying efforts (in Mexico and in the U.S.). The general partner is a Mexican-American with strong ties to her homeland. The partnership plans to employ all of the firms inputs from Mexico and sell the basketballs in the global market, using the U.S. dollar as the currency habitat of price. The project requires an initial investment of 100 million Pesos and is expected to produce profits of 50 million pesos in the first year of operation and 150 million Pesos in the second through fifth years of operations. Due to expected political unrest, the project will be terminated and all relevant capital will be salvaged at 10% of initial cost after the fifth year of operation. The current spot exchange rate is 38 pesos /1U.S. $. The risk-free interest rate is 2% in the U.S. and 7% in Mexico. The multinational thinks that the required rate of return on the market portfolio in the U.S. is 10%, and estimates that the project beta is about 1.5. There is no information on the required rate of return in Mexico.

1.) What is the all-equity cost of capital for this project?

2.) The partnership hires you as a consultant for the project. Your first deliverable is to calculate the projects net present value to determine if the project should be undertaken from an economic perspective.(Assume interest rates to remain constant for maturities one-through five).

During the first year of operation, there is a failed coup attempt against the president of Mexico. Dissidents attempt to oust the leader and members of his administration; as a result of the increase in political instability, Mexicans react by transferring capital abroad in OffShore accounts.

3.) Analyze the effect of this political event on the Mexican Pesos/US$ exchange rate. What is the net effect on the nominal and real exchange rates?

4.) Use supply/demand analysis to determine the net effect of the capital flight on the dollar-price of the firms basketballs, the number of basketballs produced and profit level. Be very precise and carefully explain your results. (The solution is graphical, not numerical.)