Question

Your firm is considering investing $7,500,000 in a factory to build home ethanol systems that will allow individuals to create ethanol from grass clippings. There is an 80% chance that the technology will work as planned and expected net cash flows will be $1,240,000 per year and a 20% chance of technical problems that will reduce expected net cash flows to $40,000 per year. Either way, net cash flows would begin a year from today and continue for 20 years (when your patents will expire and new technology will allow personal solar power systems to become viable). Alternatively, in two years, your firm will know whether the technology will work and thus whether net cash flows will be $1,240,000 or $40,000 per year. Should your firm build now or wait two years if the required return on the project is 10% per year?

Answer 1

Initial investment	7,500,000.00
Rate	10%

Year	PV factor 10% [1/(1+r)^n]
1	0.909
2	0.826
3	0.751
4	0.683
5	0.621
6	0.564
7	0.513
8	0.467
9	0.424
10	0.386
11	0.350
12	0.319
13	0.290
14	0.263
15	0.239
16	0.218
17	0.198
18	0.180
19	0.164
20	0.149
Total	8.514

Cashflow	Probability	Probable cashflow
1,240,000.00	0.8	992,000.00
40,000.00	0.2	8,000.00
Total probable inflow		1,000,000.00

Total discounted inflow=		Annual inflow * Total discount factor for 20 years
	=	1,000,000 * 8.514
	=	8,514,000.00
	NPV of project=	Discounted inflow - Initial investment
	=	8,514,000 - 7,500,000
	=	1,014,000.00

Since the NPV of the project is positive firm should go for the project now itself. They should not wait for 2 years