6. You are given the following information on the best guess of related outcomes
ID: 2733989 • Letter: 6
Question
6. You are given the following information on the best guess of related outcomes for a project. The initial cash outlay for developing and market testing the product over the next year IS $70M. Following the test, the company will spend another $400M to put the productive capabilities in place at the END of the year. If the test is successful, which is expected to have a probability of 0.8, the expected annual cash flows will be $150M for five years. If the test fails, the expected annual cash flows will be $50M for five years. The discount rate is 12%.
(a) Compute the NPV of this project at time 0 assuming that the project will be implemented regardless of the outcome of the test. Given that the value at the END of the testing year of the 5-year $150M annuity is $540.72M, and that of the 5-year $50M annuity is $180.24M. <$-8.73M> (
b) Say, you are given the option to upgrade by building a better production facility at a cost of $500M if the test fails. The upgraded facility is expected to generate annual cash flows of $100M for five years. Note that the base facility and cash flows estimates will apply if the test is successful. Compute the value of the option to upgrade at time 0. <$14.33M>
I have completed part (a). I am more interested in part (b). Please show how the $14.33M answer was derived. Please show detailed steps because I want to understand the problem as it will likely be on the exam on a different form. Thanks.
Explanation / Answer
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Intial Invt $ (70,000,000) Production Capabilities $ (400,000,000) Cash Outflow @80% 150 Prob & @20% 50 Prob $ 130,000,000 $ 130,000,000 $ 130,000,000 $ 130,000,000 $ 130,000,000 WACC @12% 116,071,429 103,635,204 92,531,432 82,617,350 73,765,491 Total Cash Outflow/(Inflow) @12 % $ (470,000,000) 116,071,429 103,635,204 92,531,432 82,617,350 73,765,491 NPV with Probability $ (1,379,094) If Test Pass 150 Mn Every year $ 133,928,571 $ 119,579,082 $ 106,767,037 $ 95,327,712 $ 85,114,028 $ (470,000,000) NPV at Pass $ 70,716,430 If Test Fail 50 Mn Every year $ 44,642,857 $ 39,859,694 $ 35,589,012 $ 31,775,904 $ 28,371,343 $ (470,000,000) NPV at Pass $ (289,761,190) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Intial Invt $ (70,000,000) test Fail new Invt $ (500,000,000) Cash Outflow $ 100,000,000 $ 100,000,000 $ 100,000,000 $ 100,000,000 $ 100,000,000 Total Disc Cash Outflow $ (570,000,000) $ 90,909,091 $ 82,644,628 $ 75,131,480 $ 68,301,346 $ 62,092,132 NPV $ (190,921,323)
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.