A venture capitalist named Kevin is considering a pitch from an entrepreneur who

Question

A venture capitalist named Kevin is considering a pitch from an entrepreneur who has invented a smart toaster, which is a wifi-enabled cooking appliance that alerts users via text-message when their toast is ready. The entrepreneur has submitted an application for a utility patent, which will take a year to process. The investment will cost Kevin $20,000 today, and if the patent is awarded, Keven will receive a payout of $44,000 one year after he makes his investment. If no patent is awarded, however, Keven receives nothing. Kevin believes there is a 60% chance the patent will be awarded. Assume the market interest rate is 10%.

a. Calculate Kevin’s net present value of making the investment today, accounting for the uncertainty in the future return. Notice that the costs of making the investment today are certain, but the benefits are uncertain.

b.Considering your answer to (a), should Kevin make the investment today? Assume he is risk-neutral when formulating your answer.

c.Calculate the net present value (today) of waiting for the patent to be processed before deciding whether to make the investment. Note that in this case, both the costs and the benefits of the investment are uncertain today.

d.What is the option value of waiting? Should Kevin make the investment today or wait until next year?

Explanation / Answer

a. Calculate Kevin’s net present value of making the investment today, accounting for the uncertainty in the future return. Notice that the costs of making the investment today are certain, but the benefits are uncertain.

NPV = Present value of CashInflow - Cash Outflow = ($44,000 x 0.909) - $20000 = $40,000 - $20,000 = $20,000

b.Considering your answer to (a), should Kevin make the investment today? Assume he is risk-neutral when formulating your answer.

If here we assume that ris-neutral then NPV = $44,000 - $20,000 = $24,000

c.Calculate the net present value (today) of waiting for the patent to be processed before deciding whether to make the investment. Note that in this case, both the costs and the benefits of the investment are uncertain today.

Here same amount is consider as cashinflow and cashoutflow

NPV = Present value of cashinflow - Cash Outflow = ($20,000 x 0.909) - $20,000 = $18,180 - $20,000 = -$1820

d.What is the option value of waiting? Should Kevin make the investment today or wait until next year?

from above calculation Kevin should wait till one year because it will give positive and better cashflow as compare with present.

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