A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10% devaluation is expected to lower unit costs by $0.30, while a 15% devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10% or 15% is likely, with respective probabilities of 0.4 and 0.2 (the probability of no currency change is 0.4). Depreciation at the current exchange rate equals $1 million annually, and the local tax rate is 40%.
a. What will annual dollar cash flows be if no devaluation occurs?
b. Given the currency scenario described here, what is the expected value of annual after-tax dollar cash flows assuming no repatriation of profits to the United States?