The executives of Garner-Wagner Inc. are considering a project that has an up-fr
ID: 2757189 • Letter: T
Question
The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.
Refer to Exhibit 14.3. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
-$1,104,607
-$875,203
$199,328
$561,947
$898,205
A)-$1,104,607
B)-$875,203
C)$199,328
D)$561,947
E)$898,205
Explanation / Answer
Estimated net present value of the project = -Initial Investment + Annual Cash flow*PVIFA(10%,5) + Expected NPV at year 5 *PVIF(10%,5)
Initial Investment = 3000000
Annual Cash Flow = 500000
Expected NPV = Favorable Probability * Favorable NPV + Unfavorable Probabilty*0
Expected NPV = 35%*6000000 + 65%*0
Expected NPV = $ 2,100,000
Estimated net present value of the project = -3000000 + 500000*3.790787 + 2100000*0.620921
Estimated net present value of the project = $ 199,328
Answer
c) $199,328
Note : If outlook will be unfavorable than we should not invest in it and there cash flow would be zero in case of unfavorable
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