Question Five Afro Explore, a South African oil company is considering whether to invest South African rands 100 mio in order to explore the enormous gas reserves along the Kenyan Coast. The investment is expected to generate cash flows worth about Kes. 150 mio per year in real terms for ever. The firm's cost of capital is estimated to be 10%. The current exchange rate is Kes. 10 per South African rand and is expected to remain stable in real terms for ever. The firm is, however, worried that the future governments may nationalize all oil exploiting foreign enterprises like Afro Explore without compensation. If this were to happen, it is estimated it would occur at the end of the fifth year or never at all thereafter. It is assumed that if nationalization will take place, it will be after Afro Explore will have realized the fifth year's cash flows. Afro Explore has a political risk policy with ATIA which guarantees a compensation of 30% of the original investment value should nationalization occur before the seventh year. The insurance benefits will be realized a year after nationalization is effected. Required: 1) Determine the NPV of this project using the subsidiary perspective assuming no nationalization ever takes place. Should the project be accepted? 2) Determine the NPV assuming nationalization takes place as expected. Should the project be accepted? 3) If the probability of expropriation at the end of the fifth year is 30%, determine the expected NPV of this project. Should the project be accepted? 4) What is the probability of nationalization that would reverse our decision in three above?
Question Five Afro Explore, a South African oil company is considering whether to invest South African rands 100 mio in order to explore the enormous gas reserves along the Kenyan Coast. The investment is expected to generate cash flows worth about Kes. 150 mio per year in real terms for ever. The firm's cost of capital is estimated to be 10%. The current exchange rate is Kes. 10 per South African rand and is expected to remain stable in real terms for ever. The firm is, however, worried that the future governments may nationalize all oil exploiting foreign enterprises like Afro Explore without compensation. If this were to happen, it is estimated it would occur at the end of the fifth year or never at all thereafter. It is assumed that if nationalization will take place, it will be after Afro Explore will have realized the fifth year's cash flows. Afro Explore has a political risk policy with ATIA which guarantees a compensation of 30% of the original investment value should nationalization occur before the seventh year. The insurance benefits will be realized a year after nationalization is effected. Required: 1) Determine the NPV of this project using the subsidiary perspective assuming no nationalization ever takes place. Should the project be accepted? 2) Determine the NPV assuming nationalization takes place as expected. Should the project be accepted? 3) If the probability of expropriation at the end of the fifth year is 30%, determine the expected NPV of this project. Should the project be accepted? 4) What is the probability of nationalization that would reverse our decision in three above?
Chapter10: Capital Budgeting: Decision Criteria And Real Option
Section: Chapter Questions
Problem 22P
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Transcribed Image Text:Question Five
Afro Explore, a South African oil company is considering whether to invest South African
rands 100 mio in order to explore the enormous gas reserves along the Kenyan Coast. The
investment is expected to generate cash flows worth about Kes. 150 mio per year in real terms
for ever. The firm's cost of capital is estimated to be 10%. The current exchange rate is Kes.
10 per South African rand and is expected to remain stable in real terms for ever. The firm is,
however, worried that the future governments may nationalize all oil exploiting foreign
enterprises like Afro Explore without compensation. If this were to happen, it is estimated it
would occur at the end of the fifth year or never at all thereafter. It is assumed that if
nationalization will take place, it will be after Afro Explore will have realized the fifth year's
cash flows. Afro Explore has a political risk policy with ATIA which guarantees a
compensation of 30% of the original investment value should nationalization occur before the
seventh year. The insurance benefits will be realized a year after nationalization is effected.
Required:
1) Determine the NPV of this project using the subsidiary perspective assuming no
nationalization ever takes place. Should the project be accepted?
2) Determine the NPV assuming nationalization takes place as expected. Should the project
be accepted?
3) If the probability of expropriation at the end of the fifth year is 30%, determine the
expected NPV of this project. Should the project be accepted?
4) What is the probability of nationalization that would reverse our decision in three above?
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