Question

g A company is evaluating a project requiring an initial cash outflow of $2 million. The investment will generate cash flows for a period of 5 years. If the firm launches the project immediately, then the after-tax cash flows will be $1 million per year. Alternatively, if the firm delays the launch by one year, then there is a 65% likelihood that the annual after-tax cash flows will be $1.5 million and a 35% likelihood that they will be $500,000. Using a discount rate of 10%, what is the value of the option to wait

Answer 1

Step-by-step explanation:

NPV of first option = - 2 + 1 / 1.1 + 1 / 1.1² + 1 / 1.1³ + 1 / 1.1⁴ + 1 / 1.1⁵

= -2 + .909 + .826+ .751+.683+ .620 = $1.789

NPV of the second option :--

NPV when annual cash flow is 1.5 million

-2 / 1.1 + 1.5 /1.1² + 1.5/1.1³ + 1.5 / 1.1⁴ + 1.5 / 1.1⁵ + 1.5 / 1.1⁶

= -1.818 + 1.239 + 1.127+1.024+.931+.846

= -1.818 + 5.167

= 3.349

NPV when annual cash flow is 0.5 million

-2 / 1.1 + .5 /1.1² + .5/1.1³ + .5 / 1.1⁴ + .5 / 1.1⁵ + .5 / 1.1⁶

= - 1.818 + 1.722 = $ -0 .096

NPV = .65 x 3.349 - .35 x .096

= 2.177 - .0336

= $2.1434

value of option wait = $2.1434 - $1.789

= $ 0.3544