Smirnoff and Co. entertains a project that requires initial investment of $35. T

Question

Smirnoff and Co. entertains a project that requires initial investment of $35. The cost of capital is 10 percent and the risk-free rate is 6 percent. There is a 30 percent chance of high demand, with future cash flows of $45 per year for the next two years. There is a 40 percent chance of average demand, with cash flows of $30 per year for the next two years. If demand is low (a 30 percent chance), cash flows will be only $15 per year for the next two years.

1. What is the expected NPV of the project?

2. The company will have an option: it will have the opportunity to wait two years before implementing the project. What is the total expected NPV of the project with the option to wait using a decision tree analysis?

3. Based on the answers above, should the company exercise the option to wait? Why or why not? Explain.

Explanation / Answer

Answer:

1. Calculation of NPV:

Expected Future cash flows   = (30% * $45) +(40%*$30) + (30%*$15)

= $30 Per year

Present value of Expected future cash flows = $30 * PVAF (10%, 2 years )

= $30 * 1.7355 = $52.07

Initial investment = $35

NPV = Present value of Expected future cash flows - Initial investment

Hence Net present value (NPV) =52.07

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