1. Suppose that you are planning a project that will cost $60 to fund, and will
ID: 2802113 • Letter: 1
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1. Suppose that you are planning a project that will cost $60 to fund, and will generate cash flows for each of the next three years as described below: Probability of CF CF .4 20 .3 25 .3 40 You have the option to wait one year, and if you do then you will know, with certainty, if you get the outcome of 20/year, but you still won't know if you get 25 or 40. If the WACC-896, should you wait one year? Suppose with the same information regarding probabilities and cash flows as in number 1, instead of waiting a year you have the option to expand at the end of the third year by investing another $60. If the WACC is still 8%, how much would you pay for the option to expand at the end of year 2?Explanation / Answer
Project Cost $60 Period Cash flow Probability Expected cashflows Discounted cash flows @8% 0 ($60) 1 ($60) -$60.00 1 $20 0.4 $8 $7.41 2 $25 0.3 $8 $6.43 3 $40 0.3 $12 $9.53 NPV= -$36.64 Based on the probabilities the expected cash inflows are factored and discounted with WACC, which is resulting in negative NPV and hence the project cannot be taken. If the investment option at the end of 2nd year Period Cash Flow Discounted cash flows @8% 2 ($60) -$51.44 We need to pay for the expansion -$51.44
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