Question

Companies often need to choose between making an investment now or waiting till the company can gather more relevant information about the potential project. This opportunity to wait before making the decision is called the investment timing option.

Tolbotics Inc. is considering a three-year project that will require an initial investment of $41,000. If market demand is strong, Tolbotics Inc. thinks that the project will generate cash flows of $29,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,000 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.
If the company uses a project cost of capital of 11%, what will be the expected net present value (NPV) of this project?
a) -$2,986
b) -$3,733
c) -$3,360
d) -$4,293

Answer 1

The expected net present value (NPV) of the project can be calculated by determining the present value of the cash flows and subtracting the initial investment. In this case, the expected NPV is -$2,986.

Step-by-step explanation:

The expected net present value (NPV) of the project can be calculated by determining the present value of the cash flows and subtracting the initial investment. The NPV formula is:

NPV = (Cash Flow1 / (1 + r)^1) + (Cash Flow2 / (1 + r)^2) + ... + (Cash Flown / (1 + r)^n) - Initial Investment

In this case, the expected cash flows for strong demand and weak demand are $29,500 and $1,000 per year respectively, with a 50% chance for either outcome. The project cost of capital is 11% and the initial investment is $41,000. Therefore, the expected NPV can be calculated as follows:

NPV = (29500 / (1 + 0.11)^1) + (29500 / (1 + 0.11)^2) + ... + (29500 / (1 + 0.11)^3) + (1000 / (1 + 0.11)^1) + (1000 / (1 + 0.11)^2) + ... + (1000 / (1 + 0.11)^3) - 41000

Simplifying the equation, we get NPV = -$2,986. Therefore, the expected net present value of this project is -$2,986.