You have been retained to evaluate a major investment for a technology company.

Question

You have been retained to evaluate a major investment for a technology company. The cost of the project is $100 million. If the project is successful, it will generate expected profits of $15 million per year forever, which has a present value of $150 million. However, there is a 50% chance that the project will be a complete failure, in which case it will generate no cash flows. If the project is successful, there will be a follow-on project that can be initiated the following year. The follow-on project will have a cost of $1 billion, and if all goes well (probability of 50%), it will generate expected cash flows of $150 million per year that will last forever and will result in a value of $1.5 billion (in year 1 dollars). If the follow-on project is not successful, it will result in a stream of cash flows with a present value of $900 million. Should the initial project be undertaken? Explain your recommendation in commonsense terms to your boss, who is not a technology person.

Please use below for solution

PROBLEM 13-5 First Project Year 1 Year 2 Year 3 PV (good state) 150 15 15 15        prob = 50% Investment -100        prob = 50% PV (bad state) 0 0 0 0 NPV Follow-On Opportunity (Year 1) Year 2 Year 3 Year 4 PV 1500 150 150 150        prob = 50% Investment -1000        prob = 50% PV 900 90 90 NPV

Explanation / Answer

For second project NPV = initial investment +probability of sucess*payoff for success+probability of failure*payoff for failure

NPV project 2 = 1+0.5*1.5+0.5*0.9

=2.2

For project 1

NPV = nitial investment +probability of sucess*(payoff for success+NPV project 2/(1+discount rate)^n+probability of failure*payoff for failure

NPV = 0.1+0.5*(0.15+2.2/(1+0.1)^1)+0.5*0

=1.175b

NPV is positive so accept the project

Note :discount rate = Annual cash flow/PV of annual cash flow = .015/.15 = 10%

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