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Games, Inc. is considering selling tennis racquets. It can use a proven technology to produce the...

Games, Inc. is considering selling tennis racquets. It can use a proven technology to produce the racquets. This method will produce a $24M cashflow next year. The firm could also choose a new experimental method for producing racquets. This method has lower costs if it works. If the new technology works it will produce a cashflow of $28M next year. If it is unsuccessful it will produce a zero cashflow next year. The probability of success is 0.8 and the cashflows are uncorrelated with the market return. Both methods require a $20M dollar investment today. There are no cashflows after next year. The risk-free rate is 10%. The market price of risk is 8.4%. Games, Inc. has decided to raise $20M by issuing debt. The bondholders believe Games Inc’s assertion that they will use the old technology. (You could also assume that the bondholders have never heard about the new technology).

What is the NPV of the equity if the old technology is chosen? What is the NPV of the equity if the new technology is chosen? Which project will shareholders choose? [5 Marks]

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jeff jeffy answered 2 years ago
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