Question

Perini Corp is considering a project that has been assigned a discount rate of 14 percent. If the company starts the project today, it will incur an initial cost of $860,000 and will receive cash inflows of $287,000 a year for five years. If the company waits one year to start the project, the initial cost will rise to $988,000 and the cash flows will increase to $341,000 a year for five years. What is the value of the option to wait?

$42,616.74

$38,702.16

$34,951.91

$30,373.29

$26,800.35

Answer 1

$34,951.91

Value of option is the difference between net present value of both option.

Step-1:Calculation of net present value of option to start the project today
Present value of cash inflow			$    9,85,294.24
Less cost of project			$    8,60,000.00
Net Present value			$    1,25,294.24
Working:
Present value of annuity of 1 for 5 years		=	(1-(1+i)^-n)/i		Where,
		=	(1-(1+0.14)^-5)/0.14		i	=	14%
		=	3.433080969		n	=	5
Present value of cash inflow		=	Annual cash inflow	*	Present value of annuity of 1 for 5 years
		=	$    2,87,000.00	*	3.433081
		=	$    9,85,294.24
Step-2:Calculation of net present value of option to start the project after one year
Present value of cash inflow			$ 11,70,680.61
Less cost of project			$    9,88,000.00
Net Present value			$    1,82,680.61
Working:
Present value of annuity of 1 for 5 years		=	(1-(1+i)^-n)/i		Where,
		=	(1-(1+0.14)^-5)/0.14		i	=	14%
		=	3.433080969		n	=	5
Present value of cash inflow		=	Annual cash inflow	*	Present value of annuity of 1 for 5 years
		=	$    3,41,000.00	*	3.433081
		=	$ 11,70,680.61
Step-3:Calculation of net present value of option to wait one year today
Present value		=	Net Present value of option to wait a year from now	*	Discount factor
		=	$    1,82,680.61	*	0.877193
		=	$    1,60,246.15
Working:
Discount factor		=	(1+i)^-n		Where,
		=	(1+0.14)^-1		i	14%
		=	0.877192982		n	1
Step-4:Calculation of value of option to wait
Net Present value of option to wait		a	$    1,60,246.15
Net Present value of option to start the project today		b	$    1,25,294.24
Value of option to wait		a-b	$       34,951.91