ZebraEngineering Corp. is considering a three-year project that will require an

Question

ZebraEngineering Corp. is considering a three-year project that will require an initial investment of $44,000. If market demand is strong, ZebraEngineering Corp. thinks that the project will generate cash flows of $28,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,500 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

If the company uses a project cost of capital of 11%, what will be the expected net present value (NPV) of this project?

-$5,875

-$6,242

-$7,344

-$6,977

ZebraEngineering Corp. has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.

What will be the expected NPV if ZebraEngineering Corp. delays starting the project?

$4,331

$9,509

$1,840

$2,165

What is the value of ZebraEngineering Corp.’s option to delay the start of the project? selector 1

$1,840

$9,509

$2,165

$4,331

Explanation / Answer

Part 1 Now Year 1 Probability Year 2 Probability Year 3 Probability         (44,000)                                 28,500 50%                                 28,500 50%                            28,500 50%                                   1,500 50%                                   1,500 50%                               1,500 50% Now Year 1 New Cash Flow Year 2 New Cash Flow Year 3 New Cash Flow -44000 15000 15000 15000 Cost of Capital 11% PV 1 13513.51351 PV 2 12174.3365 PV 3 10967.87072 Total PV 36655.72073 NPV -7344.279268 Part 2 Cash Flows Cost of Capital Year 0                               (44,000) 11% Year 1                                 28,500 Year 2                                 28,500 NPV $4,330.55 Part 3 Cash Flows Cost of Capital Year 0                               (44,000) 11% Year 1                                 28,500 25675.67568 Year 2                                 28,500 23131.23935 Year 3                                 28,500 20838.95437 69645.86939 NPV                                 25,646

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