You are given the following information on the best guess of related outcomes fo

Question

You are given the following information on the best guess of related outcomes for a proiect. The initial cash outlay for developing and market testing the product over the next vear IS $70M. Following the test, the company will spend another S400M 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) 6 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 S50M annuity is $180.24M. (b)Say, you are given the option to upgrade by building a better production facility at a cost of S500M 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. Note: Post your answer/question(s) for part b via Canvas discussion posts!

Explanation / Answer

Project A Year Amount P V Factor Present Value Cash outflow 0 70 1 70.00 1 400 0.89 357.14 Present Value of Cash outflow 427.14 Ans (A) In case test Probability PV of cash inflow Fails 0.8 540.72 432.58 Pass 0.2 180.24 36.05 468.62 There fore NPV is 468.62-427.14 41.48 Ans (b) In case test fails Year Amount P V Factor Present Value Probability Cash outflow 0 70 1 70.00 1 400 0.89 357.14 1 500 0.89 445.00 Present Value of Cash outflow 872.14 0.2 174.43 In case test Pass Year Amount P V Factor Present Value Cash outflow 0 70 1 70.00 1 400 0.89 357.14 Present Value of Cash outflow 427.14 0.8 341.71 Total expected outflow 516.14 Cash Inflow In case test Cash Inflow PV of cash inflow Probability Fails 50 per year 180.24 100 per year 360.48 540.72 0.20 108.14 Cash Inflow In case test Cash Inflow PV of cash inflow Pass 150 per year 540.72 0.8 432.58 Total expected inflow 540.72 There fore NPV is 540.72-516.14 24.58

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