Question

You are given the following information on the best guess of related outcomes for a project. The initial cash outlay for developing and market testing the product over the next year IS $70M. Following the test, the company will spend another $400M to put the productive capabilities in place at the END of the year. If the test is successful, which is expected to have a probability of 0.8, the expected annual cash flows will be $150M for five years. If the test fails, the expected annual cash flows will be $50M for five years. The discount rate is 12%. (a) Compute the NPV of this project at time 0 assuming that the project will be implemented regardless of the outcome of the test. Given that the value at the END of the testing year of the 5-year $150M annuity is $540.72M, and that of the 5-year $50M annuity is $180.24M. ( b) Say, you are given the option to upgrade by building a better production facility at a cost of $500M if the test fails. The upgraded facility is expected to generate annual cash flows of $100M for five years. Note that the base facility and cash flows estimates will apply if the test is successful. Compute the value of the option to upgrade at time 0.

Answer 1

Expected cash inflow when project gets started= 0.8*150+0.2*50=$130 million

Below is the cash flow schedule and NPV of the project:

Year	Cash flow	Present Value of cash flow (Cash flow/1.12^year)
1	(470.00)	(419.64)
2	130.00	103.64
3	130.00	92.53
4	130.00	82.62
5	130.00	73.77
6	130.00	65.86
	Total (NPV)	(1.23)

As the NPV of the project is $-1.23 million i.e. negative, the project should not be accepted.

In case of facility upgrade, Initial outlay at the end of year 1= 70+500=570 and expected annual cash flow =150*0.8+0.2*100=140

Hence, NPV calculation is given below:

Year	Cash flow	Present Value of cash flow (Cash flow/1.12^year)
1	(570.00)	(508.93)
2	140.00	111.61
3	140.00	99.65
4	140.00	88.97
5	140.00	79.44
6	140.00	70.93
	Total (NPV)	(58.33)

So, value of the upgrade option is (-58.33+1.23)=-$57.1 million