We could pay extra money upfront and rearrange the project so that the uncertain

Question

We could pay extra money upfront and rearrange the project so that the uncertainty about the success of the technology is resolved before we have to make the second investment. To do so would require an immediate $110 million investment. If the technology is unsuccessful we will abandon the project. If the technology is successful, we will have to invest another $100 million at the end of year 1, and the technology will generate free cash flows of $80 million starting at the end of year 2 up to infinity, as in the previous case.

Assuming a discount rate of 20%, what should we do?

Explanation / Answer

Initial Cash outflows = -$110 million

Discount rate = 20%

If successful:

Cash flows:
Year 1 = -$100
Year 2 = $80 million to infinity

PV of Cash flows = -$100 million / 1.20 + $80 million / 1.20^2 + $80 million / 1.20^3 + ....
PV of Cash flows = -$100 million / 1.20 + ($80 million / 1.20) / 0.20
PV of Cash flows = $250.00 million

If unsuccessful:

Cash flows = 0

There is 50% chance for the project to be successful and 50% chance for the project to be unsuccessful.

Expected PV of Cash flows = 50% * $250.00 million + 50% * $0
Expected PV of Cash flows = $125.00 million

Net Present Value = Initial Cash flows + Expected PV of Cash flow
Net Present Value = -$110.00 million + $125.00 million
Net Present Value = $15.00 million

So, NPV of investing in this techonology is $15.00 million

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