Question

Dynamic Industries is considering a new project. The project may begin today or in exactly two years. The project will cost £11.5 million to start today. The cost of starting the project in two years is £13 million. You expect the project to generate £1,200,000 in free cash flow per year forever. The risk-free rate is 4%. The expected return on the market is 8%, and beta for projects of similar risk is 1.5. The variance of the project's cash flows is 12.25%.

REQUIRED:
i) What is the value of the option to wait until year 2 to start the project?
ii) Should you begin the project today or wait for two years?

Answer 1

To determine the value of the option to wait until year 2 to start the project, calculate the present value of the cash flows for both scenarios. Then compare the present values to decide whether to start the project today or wait.

Step-by-step explanation:

To determine the value of the option to wait until year 2 to start the project, we need to calculate the present value of the cash flows for both scenarios. The present value of starting the project today is calculated by discounting the cash flows at the risk-free rate. The present value of starting the project in two years is calculated by discounting the cash flows at the risk-free rate plus the risk premium.

After calculating the present value for both scenarios, we can compare them to determine the value of the option to wait. If the present value of starting the project today is higher, it would be more favorable to begin the project today. If the present value of starting the project in two years is higher, it would be more favorable to wait until year 2 to start the project.