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.

Cost of capital is 10%.

a) What would be the expected NPV if the firm invests today?

b) What would be the expected NPV if the firm waits for two years before deciding?

c)

What should the firm do – invest now or wait?

d) Calculate value of the option to wait.

Answer 1