A potential new project for Anthem Corp. would cost $1000 today. The 1st stage o

Question

A potential new project for Anthem Corp. would cost $1000 today. The 1st stage of the project would last 2 years. There are 2 possible scenarios for Stage 1 net cash flows in years 1 and 2: 1) $1080 per year, with 50% probability; or 2) $0 per year, with 50% probability. If the 1st stage outcome is good (with non-zero outcomes), Anthem Corp. will reinvest an equal amount in year 2 (the same amount invested at year 0) and extend the project into Stage 2 (years 3 and 4). The possible Stage 2 outcomes are either: 1) net cash flows in years 3 and 4 doubling relative to the good Stage 1 outcome (with probability of 50%), or 2) net cash flows of 0 in years 3 and 4(with probability of 50%). If the Stage 1 outcome is bad, Anthem Corp. will abandon the project at the conclusion of Stage 1. The cost of capital is 7%. The overall expected NPV of the project (at year 0), considering Stage 1 and the option to expand the project into Stage 2, is $_______. Answer:

Explanation / Answer

Possible Event $ A 1080 in Year 1, 1080 in year 2, 2160 in year 3, 2160 in year 4 B 1080 in year 1, 0 in year 2, 0 in year 3, 0 in year 4 C 1080 in year 1, 1080 in year 2, 0 in year 3, 0 in year 4 D 0 in year 1, 0 in year 2 Event NPV Estimate Probability Expected NPV Estimate A (1080x0.935) + (1080x0.873) + (2160x0.816) + (2160x0.762) - 1000 = 4361 (0.50 x 0.50) = 0.25 1090 B (1080x0.935) + (0x0.873) + (0x0.816) + (0x0.762) - 1000 = 10 (0.50 x 0.50) = 0.25 3 C (1080x0.935) + (1080x0.873) + (0x0.816) + (0x0.762) - 1000 = 953 (0.50 x 0.50) = 0.25 238 D (0x0.935) + (0x0.873) - 1000 = -1000 (0.50 x 0.50) = 0.25 -250 Expected NPV 1081

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