Question

A product based on a new technology has two major potential markets. The dominant uncertainty associated with it has to do with the technology rather than the markets. Accordingly, the product will succeed in both or fail in both, with equal probability. The markets are otherwise independent and may be entered sequentially or simultaneously either now, one year from now, or two years from now. Market A requires an initial investment of $100 regardless of when it is entered. If the product is successful, market A will have a present value of $160 one year after entry. If the product fails, market A will be worth $80 one year after entry. Market B requires an initial investment of $55 regardless of when it is entered. One year after entry, B will have a present value of $140 or $25 for success and failure, respectively. For simplicity, perform all discounting in this problem at 5%.

a) What is the NPV for each market, assuming each is entered immediately? - Already answered using risk netural probability; obtained an option value of $25 for both markets, but not sure if that is correct.

Answer 1

The Net Present Value (NPV) for Market A is -$24.19 and for Market B is $54.52. The NPV calculation takes into account future cash flows and discounts them to their present values using a discount rate of 5%.

Step-by-step explanation:

To calculate the Net Present Value (NPV) for each market, we need to consider the future cash flows and discount them to their present values using a discount rate of 5%. For Market A, the initial investment is $100 and the future cash flows are $160 if successful and $80 if it fails after one year. The present value of Market A is calculated as:

NPV = ($160 / (1 + 0.05)^1) + ($80 / (1 + 0.05)^1) - $100 = $152 - $76.19 - $100 = -$24.19

Similarly, for Market B, the initial investment is $55 and the future cash flows are $140 if successful and $25 if it fails

after one year. The present value of Market B is:

NPV = ($140 / (1 + 0.05)^1) + ($25 / (1 + 0.05)^1) - $55 = $133.33 - $23.81 - $55 = $54.52

Therefore, the NPV for Market A is -$24.19 and the NPV for Market B is $54.52.