If diplomat goes ahead with this project today, it will obtain knowledge that wi

Question

If diplomat 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 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 net present value of -$6 million at t = 5. Diplomat.com 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? A) -$1,104,607 B) -$875,203 C)$199,328 D)$561,947 E) $898,205.

Explanation / Answer

First find the expected value of the future oporunities. Remember, he does not have to pursue the future opportunity if the outlook is unfavorable so we only need to consider the expected value of the favorable outcome.

.35 x 6 million = 2.1 million
.65 x 0 = 0 (This is because if the outcome is unfavorable, he will not pursue the opportunity)
2.1 million - 0 = 2.1 million.

ERROR: Further analysis requires discount rate. Without a provided discount rate, you cannot solve the problem precisely. However, problem can still be solved via process of elimination. Only answer choice A can be correct (because the other choices are impossible).

After you discount the 2.1 million to its present value you should subtract the initial investment of 3 million and you will get a number slightly less than -0.9 million (or -900,000) because if you discount 2.1 million (to, lets say, 1.9 million) you will get -1.1 million.

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