You are the chief financial officer of Clad Metal, a U.S. multinational with operations throughout the world. Your capital budgeting department has presented a proposal to you for a 5-year ore-extraction project in Mexico. The expected year-end net dollar cash flows are as follows:
The initial required investment in plant and equipment is $500,000, and the cost of capital is 16%.
a. What is the present value of the project? Should the project be undertaken?
b. You notice that the proposal does not include any analysis of political risk, but you are concerned about potential expropriation of the investment. Therefore, you decide to call a meeting to discuss political risk. Who would you invite to this meeting? What information or data would you need? How would you arrive at a political risk probability estimate?
c. Assume that, at the end of the meeting, you decide that the probability of expropriation is between 5% and 7%. Also assume that there is no compensation in the case of expropriation. Would you approve the project?
d. Given the possibility of expropriation; might you want to reconsider converting Mexican peso expected cash flows at forward rates?