Digital Inc. is considering production of a new cell phone. The project would re

Question

Digital Inc. is considering production of a new cell

phone. The project would require an investment of $20 million. If the phone

were well received, then the project would produce cash flows of $10 million a

year for 3 years, but if the market did not like the product, the cash flows

would be only $5 million per year. There is a 50 percent probability of both

good and bad market conditions. Digital could delay the project for a year

while it conducted a test to determine if demand would be strong or weak.

The delay would not affect either the project%u2019s cost or its cash flows. Digital%u2019s

WACC is 10 percent. What action would you recommend?

Immediately Year 0 Year 1 Year 2 Year 3 Cash flows NPV = Strong demand (50% probability) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flows NPV = Weak demand (50% probability) Year 0 Year 1 Year 2 Year 3 Year 4 Cash flows NPV = What action do you recommend and why?

Explanation / Answer

immidiately

(10+5)/2=7.5

7.5*2.486=18.645

PVAF(10%,3 year)=2.486

NPV= 18.645-20=-1.35

strong

PV of inflow= 10*2.486=24.86

NPV=24.86-20=4.86

weak

PV of inlow=5*2.486=12.43

NPV=12.43-20=-7.57

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