Project #52588 - Finance Homework

Just need help with the following:

 

Mom and Pop Groceries has a two-year contract to supply groceries to the

government of the Central Antarctic Republic. The contract calls for two

payments of $500,000 after each of two annual shipments arrives by snow

train. The first payment should be received 12 months from now and the

second 24 months from now.

 

Unfortunately there is a 20% per year chance of a coup d’état, in which case

the new government will not pay. Thus the probability of receiving the first

payment is only 80%. If the existing government survives and makes the

first payment, Mom and Pop will face the same 20% risk of non-payment in

year two.

 

Mom and Pop’s controller therefore decides to discount the payment at 32%,

rather than at the company’s 12% cost of capital. (12% + 20% = 32%)

 

a. What’s wrong with using a 32% discount rate to offset this

political risk?

 

b. How much are the $500,000 payments really worth if the odds of a

coup d’état are 20% in year 1 and again 20% in year 2 if the

government survives in year 1?

Subject Business
Due By (Pacific Time) 12/21/2014 09:00 pm
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