On January 1, 20X1, Enterprise Company has the opportunity to invest in a projec

Question

On January 1, 20X1, Enterprise Company has the opportunity to invest in a project with an uncertain outcome. The product might be a hit and very profitable, or it might not. To put specific numbers to it, there is a 50 percent chance that the payoffs will be an annuity of $1,000 per year for three years. There is also a 50 percent chance that the payoffs will be an annuity of $500 per year for three years. The payoff on December 31, 20X1 is when Enterprise discovers whether the product is a hit or not. If the payoff is $1,000, then the other years will also be $1,000. If the payoff is $500, then the other years will also be $500. The alternative use of money is to invest it at 10 percent.

a. What is the present value of the expected value of the project?

b. As it happens, the land, building, and equipment have alternative uses, which means that anytime during the project Enterprise could stop the project and turn to a new project (project 2). If numbers were put to it, Enterprise anticipates that this possible other project has a present value of $1,500 as of the end of year 20X1. This means that Enterprise would have the new project (project 2) with a present value of $1,500 plus the $500 (or a total of $2,000) outcome if they switched projects on December 31, 20X1. What is the present value as of January 1, 20X1 of the first project including the option to move to the new project (project 2) at the end of 20X1?

c. What is the value as of January 1, 20X1 of being able to opt out of this first project if it turns out to have a low payoff? The value of this option is the increase in present value of part b. compared to part a. I think this is sometimes called the value of the abandonment option.

d. Does accounting have the possibility to tell you which path the company is on (the product is a hit or not)? Elaborate on one danger that keeps accounting from being perfect in this regard.

Explanation / Answer

Answer for question no.1:

Given required rate of return =10%.

Probability that the pay off for the project is $1000 is 0.50 for year 1 and as it is certain for the following years probability is 1

Probability that the pay off for the project is $500 is 0.50 for year1 and as it is certain for the following years probability is 1.

Expected pay offs are present in the following table:

Present value of the expected value of the project is $2032.31+$1250= $3,282.31.

Answer for question no.b:

Present value of the project if the project is abondoned at the end of year 1 is cash flow from the project i.e., $2,000 * present value factor at 10% i.e., 0.909*$2,000=$1,818.18.

Answer for question no.c:

Opportunity cost of moving out of the project is expected present value of the project under Option a and the present value of the project under option b =$3,281.31 - $1,818.18 =$1,464.12.

Answer for question no.d:

Accounting does not have the possibility to tell wich path the company is on reason being, the uncertainity involved over the outcome of the project.and this is the danger that keeps accounting from being perfect.

Year Particulars return Present value factor Present value Probability Present value of expected cash inflows Return Probability Present value of expected cash inflows 1 Cash inflows $1,000.00 0.909090909 $909.09 0.5 $454.55 $500.00 0.5 $250.00 2 Cash inflows $1,000.00 0.826446281 $826.45 1 $826.45 $500.00 1 $500.00 3 Cash inflows $1,000.00 0.751314801 $751.31 1 $751.31 $500.00 1 $500.00 $2,032.31 $1,250.00

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