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Problem Set 7

Assigned Problem 1

NPC is considering either to invest in a project for a new product immediately or 1 year later. If NPC invests in the project today, there will be 75% chance of good market acceptance of the product and 25% chance of bad market acceptance of the product. If market reaction to the new product is good, a cash inflow of \$500 million will be realized each year for the next 7 years. If market reaction to the new product is bad, a cash inflow of \$25 million will be realized each year for the next 7 years. However, if NPC chooses to wait for 1 year to obtain more information about market tastes, the company would know definitely about the market reaction and would then either proceed with the project or not invest in it at all. The initial cost of the project is \$1,500 million.

1. Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding and the project will still end 7 years from now, how much will this increase or decrease the project’s expected NPV in today’s dollars (i.e., at t = 0), relative to the NPV if it proceeds today?

1. Using the same data, estimate the effect of waiting on the project’s risk i.e. calculate by how much the one-year delay will reduce the project’s coefficient of variation. (Hint: Use the expected NPV.)

Assigned Problem 2

1. Garner-Wagner is considering investing in a project that requires an investment of \$3,000,000. The project will generate a cash inflow of 500,000 per year for the next 5 years. The cost of capital is 10%. What is the project’s net present value?

1. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a positive net present value of \$6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a negative net present value of -\$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the \$3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?

Assigned Problem 3

1. SI Inc. is considering investing in a new product named Z90. There is a 50% chance that the product will be a success, which then generates \$110,000 cash inflow each year for the next 5 years. There is a 50% chance that the product will fail, which then generates \$25,000 cash inflow each year for the next 5 years. The project requires an initial investment of \$250,000. Based on the above information, what is the expected net present value of this Z90 project if the cost of capital is 12%?

1. Now, assume that one year from now, SI Inc. will know whether the Z90 has become the industry standard. Assume also that after receiving the cash flow at t = 1, SI Inc. has the option to abandon the Z90 project, in which case it will receive an additional \$100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?

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