The executives of Garner-Wagner Inc. are considering a project that has an up-fr

Question

The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.

Refer to Exhibit 14.3. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?

-$1,104,607

-$875,203

$199,328

$561,947

$898,205

-$1,104,607

-$875,203

$199,328

$561,947

$898,205

Explanation / Answer

step1:

calculate initial investment

initial investment = 3,000,000

step2:

Find present value of cash flows upto t=5

PV = 500000 * [1-(1+10%)^-5]/10%

= 1,895,393.39

step3:

find the expected netpresent value of future oppourtunity at t=5

expected net present value = 0.35 * 6,000,000 + 0.65 * -6,000,000

= -1,800,000

step4:

find the net present value of future oppourtunity at t=0

= -1800000/(1+10%)^5

= -1,117,658.38

since the net present value of future oppoutunity is negative, the firm will not go a head with the future oppurtunity

step5:

find net present value of the project

NPV = -3,000,000 + 1,895,393.39

= -1,104,607 ...........ans

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