Question

Your firm is considering a project with a discount rate of 10%. If you start the project today, your firm will incur an initial cost of $480 and will receive cash inflows of $300 per year for 3 years with the first cashflow occurring one year from today. If you instead wait one year to start the project, the initial cost will rise to $520 and the cash flows will increase to $350 a year for the following 3 years with the first cashflow occurring two years from today. Would your firm be better off starting the project now or waiting to start the project in one year? Explain clearly including an estimate of the value of the option to wait.

Answer 1

We can make use of Net Present Value(NPV) formula for both the project investment options

To do that, we need to calculate the present value of all the cash flows.

Present value = Cash flow(i)/(1+ discount rate)^i where i = time period

For Project 1:

Discount rate	10%
Years	0	1	2	3
Cashflow	480	300	300	300
PV	480	272.73	247.93	225.39

So, NPV = -initial Investment + Sum of PV of year 1-3

NPV = -480 +746 = 266

For Project 2:

Discount rate	10%
Years	1	2	3	4
Cashflow	-520	350	350	350
PV	-472.73	289.26	262.96	239.05

So, NPV = -PV of initial Investment + Sum of PV of cash inflows for year 2-4

NPV = -473 + 791 = 319

So, based on the NPV calculation, we see that Project 2 is more favorable because of higher NPV value. So, it is better to wait for 1 more year than go ahead today.