A project has a cost of $50 million. The quality of the project is uncertain. Th

Question

A project has a cost of $50 million. The quality of the project is uncertain. There is a 50% chance that it is a good project and a 50% chance it is a bad project. If the project is good, the cash flow will be $20 million per year for five years. If the project is bad, the cash flow will be $10 million per year for five years. (The first cash flow from the project will occur one year from today.) You will learn whether the project is good or bad, immediately after you invest in it. How much would you be willing to pay to find out whether the project is good or bad before making your decision to invest? The appropriate discount rate for the project is 10%.

A. $2.07 million

B. $21.34 million

C. $12.91 million

D. $6.05 million

Explanation / Answer

Answer: A. $6.86 million

calculation of the NPV of the Project:

NPV=-50 million+0.50(20 million *PVIFA10%,5)+0.50($10 million*PVIFA10%,5)

=-50 million+0.50*(20*3.7908)+0.50(10*3.7908)

=-50+37.908+18.954

=6.86 million

NPV=6.86

Investment=50 million

Net=42.68/2=21.34 million

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