Weghorst Co. is considering a three-year project that will require an initial in

Question

Weghorst Co. is considering a three-year project that will require an initial investment of $45,000. It has estimated that the annual cash flows for the project under good conditions will be $60,000 and $10,000 under bad conditions. The firm believes that there is a 60% chance of good conditions and a 40% chance of bad conditions.

If the firm is using a weighted average cost of capital of 8.0000%, what will be the expected net present value (NPV) of the project?

$58,084

$37,755

$31,946

$40,659

Weghorst Co. wants to take a potential growth option into account when calculating the project’s expected NPV. If conditions are good, the firm will be able to invest $2,000 in year 2 to generate an additional cash flow of $15,000 in year 3. If conditions are bad, the firm will not make any further investments in the project.

Using the information from the preceding problem, determine what the expected NPV of this project will be when taking the growth option into account.

$64,200

$67,410

$57,780

$70,620

What is the value of Weghorst Co.’s growth option? --------------------

Explanation / Answer

Part A          
          
Initial Investment = 45,000          
          
Calculation of annual cash flow = 40,000 (60,000*60/100 + 10,000*40/100)          
          
Year    Cash flows    Discount factor @ 8%    Cash flow after discounting
1.00    40,000.00            0.93                                         37,037.04
2.00    40,000.00            0.86                       34,293.55
3.00    40,000.00            0.79                   31,753.29
Cash flow after discounting [A]                 103,083.88
Initial Investment                 [B]                 (45,000.00)
NPV of project                  [A-B]                  58,083.88

Expected Net present value of the project is $58,084 (Option A).

Part B                                
                                  
Initial Investment = 45,000          

Investment after 2 years if good condition exist = 1,032 {2,000*60%(Probability if good condition exist)*0.86(Discount factor @8% for 2 years)}  
      
Total Initial investment = 46,032 [45,000 + 1,032]  
      
Calculation of annual cash flow for 3rd year = 49,000 (75,000*60/100 + 10,000*40/100)          
          
Year    Cash flows    Discount factor @ 8%    Cash flow after discounting
1.00    40,000.00             0.93                     37,037.04
2.00    40,000.00             0.86                                         34,293.55
3.00    49,000.00             0.79                                         38,897.78
Total cash flow after discounting [A]                            110,228.37
Initial Investment                         [B]                             (46,032.00)
NPV of project                            [A-B]                            64,196.37
              

Expected Net present value of the project is $64,200 (Option A) .

Related Questions

Navigate

• Browse (All)
• Browse W
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.