There is a 6 year investment opportunity. $1.5 million today to build a plant. I

Question

There is a 6 year investment opportunity. $1.5 million today to build a plant. It takes 2 years to build the plant and can either sell, without an option to build another plant, for $12 million with a probability of 20% or for zero with a 65% probability. The risk-adjusted discount rate is 16% and the simple annual risk-free interest rate is 4%. The annual standard deviation of returns for this project is calculated as 320% and volatility remains constant for the next 6 years. If we don’t build today, we have the option to build at any time over the next 6 years. Should the investment be made today to build the plant? Show all calculations and work.

Explanation / Answer

We need to calculate the net present value of the project The expected return = 12000000*20%= 2400000 formula pv of return = $1,783,590.96 PV(16%,2,,-240000) PV(16%,2,,-2400000) Net present value = -1500000+1783590.1= 283590.1 Since NPV is positive we should undertake the project the project today

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