Digital Inc. is considering production of a new cell phone. The project will req

Question

Digital Inc. is considering production of a new cell phone. The project will require an investment of $20 million. If the phone is well-received, the project will produce cash flows of $10 million a year for 3 years; but if the market does not like the product, the cash flows will be only $5 million per year. There is a 50% probability of both good and bad market conditions. Digital can delay the project a year while it conducts a test to determine whether demand will be strong or weak. The delay will not affect the project's cost or its cash flows. Digital's WACC is 10%. What action do you recommend?

Explanation / Answer

Initial Investment 20 million Situation Cash flow Prob Years Good 10 0.5 3 bad 5 0.5 3 WACC 10% PV of cash flow in Good market         24.87 PV of cash flow in Bad market         12.43 Situation Cash flow Prob PV Prob*PV Good 10 0.5         24.87         12.43 bad 5 0.5         12.43           6.22 NPV         -1.35 Since the project has a negative NPV he should wait for a year.

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