Suppose a firm projects a $5 million perpetuity from an investment of $20 million in
Spain. If the required
return on this investment is 20 percent, how large does the probability of expropriation in
year 4 have to be before
the investment has a negative NPV? Assume that all cash inflows occur at the end of each
year and that the
expropriation, if it occurs, will occur prior to the year-4 cash inflow or not at all. There is
no compensation in the
event of expropriation.
ANSWER. This problem can be solved by breaking the cash flow stream into two
components–one component if
expropriation takes place and the other if no expropriation takes. The expected value of
these streams is found by
multiplying the first component by the probability that expropriation will take place and
the other component by the
probability that expropriation will not take place. Note that the cash flow streams are
identical prior to year 4. All
numbers are in millions of dollars.