Question

Chrustuba Inc. is evaluating a new project that would cost $8.4 million at t = 0. There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $6.2 million during Years 1, 2, and 3. However, there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the project is highly successful, it would open the door for another investment of $12 million at the end of Year 2, and this new investment could be sold for $24 million at the end of Year 3. Assuming a WACC of 10.5%, what is the project's expected NPV (in thousands) after taking into account this growth option?

Answer 1

To calculate the project's expected NPV, we need to evaluate the cash flows, calculate the present value for each year, and the present value of the growth option. After discounting the cash flows and the growth option using the WACC of 10.5%, we sum up the present values to calculate the expected NPV. The expected NPV for this project is $10.96 million.

Step-by-step explanation:

To calculate the project's expected NPV, we need to evaluate the cash flows and calculate the present value. In Year 1, 2, and 3, there is a 50% chance of generating after-tax cash flows of $6.2 million and a 50% chance of generating $1 million. The expected cash flow for each year would be the weighted average of these two possibilities: (0.5 * $6.2 million) + (0.5 * $1 million) = $3.6 million. To calculate the present value, we discount the cash flows using the WACC of 10.5%. Using the formula NPV = (Cash Flow / (1 + WACC)^n), where n is the year, we calculate the present value of the expected cash flows for each year: Year 1: $3.6 million / (1 + 0.105)^1 = $3.26 million, Year 2: $3.6 million / (1 + 0.105)^2 = $2.88 million, Year 3: $3.6 million / (1 + 0.105)^3 = $2.61 million.

Now, let's consider the growth option. There is a 50% chance that the project is highly successful and opens the door for another investment of $12 million at the end of Year 2. We calculate the present value of this growth option by discounting the investment using the WACC: PV = $12 million / (1 + 0.105)^2 = $9.61 million. Finally, we calculate the expected NPV by summing up the present values of the cash flows and the growth option: NPV = ($3.26 million + $2.88 million + $2.61 million + $9.61 million) - $8.4 million = $10.96 million.