A new company wants to manufacture a product. The President of the company has d

Question

A new company wants to manufacture a product. The President of the company has decided that he must choose between one of two designs to use in making the product. The designs have the following cash flows and payoffs, listed below. Assume zero cost of capital.

Cash flow for year 0 for both designs is -$280 million.                                    

Cash flow for year 1 for project 1 --- unfavorable (50% probability) $200 million, favorable (50% probability) $400 million

Cash flow for year 1 for project 2--- unfavorable (50% probability) $100 million, favorable (50% probability) $460 million

a) Which of the two is better, and why?
b) If the company is financed entirely by equity, which design should be chosen?
c) If the company borrows $0 million and raises the other $60 million internally to pay for the design , which design should be selected?

Explanation / Answer

Answer:-Fact: Cash flow for the zero year is $280 Millon(i.e. The Cost) for both the projects

:- Calculation of Cash Flow for year 1 on the basis of probablity from Project 1                                

Probablity(Unfavourable)  Cash Flow     Probablity(Favourable)  Cash Flow        Combined Cash Flow

    50%                                    $200               50%                            $400          ($200X50%+$400X50%) =$300

:- Calculation of Cash Flow for year 1 on the basis of probablity from Project 2                             

Probablity(Unfavourable)  Cash Flow     Probablity(Favourable)  Cash Flow        Combined Cash Flow

    50%                                    $100               50%                            $460          ($100X50%+$460X50%) =$280

Answer Sub Part:-

(a) Project 1 is better , its combined probablity of cash flow (i.e. $ 300) is higher than the Project 2 (i.e. $ 280)

(b) If the company plan to finance the entire project from its Equity resources then also the company should choose the project 1.

(c)If the company rises $60 million internally then also the company should choose project 1 as its overall cash flow is higher, and it can provide better cash flow. The management may earn higher return by choosing Project 1.

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