Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Central Antarctic Republic. Payment of $250,000 will be made one year hence after the shipment arrives by snow train. Unfortunately there is a good chance of a coup d’état, in which case the new government will not pay. Mom and Pop’s controller therefore decides to discount the payment at 40%, rather than at the company’s 12% cost of capital.
a. What’s wrong with using a 40% rate to offset political risk?
b. How much is the $250,000 payment really worth if the odds of a coup d’état are 25%?
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