Damon Corp. is considering a new product that would require an investment of $20

Question

Damon Corp. is considering a new product that would require an investment of $20 million at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $10 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $4 million per year. There is a 50% probability that the market will be good. Damon could delay the project for a year while it could conduct a test to determine if demand would be strong or weak. The project

Explanation / Answer

Cash flow in $ mn, yearwise is given by strong demand: -18 12 12 12 => NPV = 12.70331 weak demand: -18 6 6 6 => NPV = - 2.6483 Average NPV = 0.5 (NPV1+NPV2) = - $5.0275 mn If investment timing option is considered: Cash flow in $ mn Strong demand: 0 -18 12 12 12 => NPV = 11.718 Weak demand: 0 - - - - - - - -- - -- -- - => NPV = 0 Hence Expected value in $ mn = 0.5 (11.718+0) =5.859461 Answer: Value of project after considering the timing option is "$ 5,859,461"

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