Western Shores is considering a project that has an initial cost today of $12,50

Question

Western Shores is considering a project that has an initial cost today of $12,500. The project has a two-year life with cash inflows of $7,400 a year. Should the firm opt to wait one year to commence this project, the initial cost will increase by 4 percent and the cash inflows will increase to $7,900 a year. What is the value of the option to wait if the applicable discount rate is 9.5 percent?

Question 6 options:

Western Shores is considering a project that has an initial cost today of $12,500. The project has a two-year life with cash inflows of $7,400 a year. Should the firm opt to wait one year to commence this project, the initial cost will increase by 4 percent and the cash inflows will increase to $7,900 a year. What is the value of the option to wait if the applicable discount rate is 9.5 percent?

Explanation / Answer

Initial cost after one year = 12,500*1.04 = 13,000

Cash flows on the succeding two years = 7,900

Present value of wait after 1 year = 7,900/1.095^2 + 7,900/1.095 -13,000 = 803.298

Present value today of wait = 803.298/1.095 = 733.606

Present value of not waiting = 7,400/1.095^2 + 7400/1.095-12,500 = 429.672

Value of wait = 733.606 -429.672 = $303.94

Answer: $303.94 (Option C)

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