6. You are given the following information on the best guess of related outcomes
ID: 2734076 • Letter: 6
Question
6. You are given the following information on the best guess of related outcomes for a project. The initial cash outlay for developing and market testing the product over the next year IS $70M. Following the test, the company will spend another $400M to put the productive capabilities in place at the END of the year. If the test is successful, which is expected to have a probability of 0.8, the expected annual cash flows will be $150M for five years. If the test fails, the expected annual cash flows will be $50M for five years. The discount rate is 12%.
(a) Compute the NPV of this project at time 0 assuming that the project will be implemented regardless of the outcome of the test. Given that the value at the END of the testing year of the 5-year $150M annuity is $540.72M, and that of the 5-year $50M annuity is $180.24M. <Answer: $-8.73M>
( b) Say, you are given the option to upgrade by building a better production facility at a cost of $500M if the test fails. The upgraded facility is expected to generate annual cash flows of $100M for five years. Note that the base facility and cash flows estimates will apply if the test is successful. Compute the value of the option to upgrade at time 0. <Answer: $14.33M>
NOTE: I have completed part (a). I am more interested in part (b). Please show how the $14.33M answer was derived. Please show detailed steps because I want to understand the problem as it will likely be on the exam on a different form. Thanks.
Explanation / Answer
My solution for the first part itself is as below. This is different from your solution. However, for part (b) I need to know if $500M is additional investment to the initial investments and is the inflow additional to those given in part (a). As an additional investment of $500m with inflow of 100m each for 5 years will not give a positive NPV of $14.33.
Particulars Amount Initial outlay (70.00) Additional outlay at end of year (357.14) Total Ouflow for the project (427.14) PV fo $ 150 M for Year 1 $133.93 PV fo $ 150 M for Year 2 119.58 PV fo $ 150 M for Year 3 106.77 PV fo $ 150 M for Year 4 95.33 PV fo $ 150 M for Year 5 85.11 Inflow for 5 years, @ probability of 0.8 $432.57 PV fo $ 50 M for Year 1 $44.64 PV fo $ 50 M for Year 2 39.86 PV fo $ 50 M for Year 3 35.59 PV fo $ 50 M for Year 4 31.78 PV fo $ 50 M for Year 5 28.37 Inflow for 5 years, @ probability of 0.2 $36.05 NPV of the project $41.48Related Questions
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