Question

In: Finance

You are evaluating a project and during the initial evaluation you determine that there are nine...

  1. You are evaluating a project and during the initial evaluation you determine that there are nine states that could occur along two variables. The first variable is the cost of money, and you predict the following costs and probabilities:

-- the company could borrow at a weighted average cost of capital of 8% -- this has a 25% chance of occurring

-- the company could borrow at a weighted average cost of capital of 9%-- this has a 40% chance of occurring

-- the company could borrow at a weighted average cost of capital of 10% -- this has a 35% chance of occurring

The second variable is the intensity of competition, and you predict the following intensities and probabilities:

-- the competition is intense -- this has a 20% chance of occurring

-- the competition is normal -- this has a 50% chance of occurring

-- the competition is weak -- this has a 30% chance of occurring

The net present values for each of the nine outcomes are listed below:

Net Present Values:

Weighted Average Cost of Capital

Note

Bracketed numbers are negative

8.00%

9.00%

10.00%

25.00%

40.00%

35.00%

Competition

Intense

20.00%

$ 500,000

$ (50,000)

$ (100,000)

Competition

Normal

50.00%

$ 700,000

$   350,000

$ 100,000

Competition

Weak

30.00%

$ 900,000

$ 650,000

$ 300,000

Joint Probabilities:

Weighted Average Cost of Capital

8.00%

9.00%

10.00%

25.00%

40.00%

35.00%

Competition

Intense

20.00%

Competition

Normal

50.00%

Competition

Weak

30.00%

Expected value

___________________________

Please enter the joint probabilities and the expected net present value in the boxes above.

_________________

Solutions

Expert Solution

Calculation of joint probability

Probability of intense competition = 20%

Probability of Company borrowing at a WACC of 8% = 25%

So, Joint Probability of intense competition & Company borrowing at a WACC of 8%

= 20% * 25% = 5%

Similarly, other joint probabilities are calculated and calculated joint probabilities are as follows

8.00%

9.00%

10.00%

25.00%

40.00%

35.00%

Competition

Intense

20.00%

5.00%

8.00%

7.00%

Competition

Normal

50.00%

12.50%

20.00%

17.50%

Competition

Weak

30.00%

7.50%

12.00%

10.50%

Net present values for each of the nine outcomes is given as follows –

8.00%

9.00%

10.00%

25.00%

40.00%

35.00%

Competition

Intense

20.00%

      500,000

       (50,000)

      (100,000)

Competition

Normal

50.00%

      700,000

      350,000

        100,000

Competition

Weak

30.00%

      900,000

      650,000

        300,000

Expected Net Present value is calculated by multiplying Net Present Value for an outcome by the joint probability for that outcome.

For example, Expected net present value for outcome of intense competition & Company borrowing at a WACC of 8% = 5% * 500,000 = $25,000

Similarly, Expected net present values for nine outcomes is calculated and the values are as follows

8.00%

9.00%

10.00%

25.00%

40.00%

35.00%

Competition

Intense

20.00%

        25,000

         (4,000)

          (7,000)

Competition

Normal

50.00%

        87,500

        70,000

          17,500

Competition

Weak

30.00%

        67,500

        78,000

          31,500

Now, Total Expected Net Present Value is the sum of the individual expected net present value calculated for the nine outcomes

Expected Net Present Value = 25000 -4000 -7000 +87500+70000+17500+67500+78000+31500

Expected Net Present Value = $366,000

jeff jeffy answered 1 year ago
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