Question

Micron Inc. can invest $5,000,000 in a new technology. Micron’s CFO is concerned about uncertainty of the future interest rates. She believes that future interest rates may be either 12% or 7% into foreseeable future. The risk-neutral probability that interest rates will be at 7% is 60%. The one-year risk-free interest rate is 5%; the rate on a risk-free 20-year bond is 10% and the rate on an equivalent 20-year callable bond is 8.5%.
New project will provide Micron an annual cash flows of $570,000 per year for the next 20 years. Should Micron accept this project? Why or why not?

Answer 1

Year	CashFlow in $	Discount rate(10%)		Excel Formula
0	5000000	5000000.0	cashflow/(1+discount rate)^year	B2/((1+(10/100))^A2)
1	570000	518181.8
2	570000	471074.4
3	570000	428249.4
4	570000	389317.7
5	570000	353925.2
6	570000	321750.1
7	570000	292500.1
8	570000	265909.2
9	570000	241735.6
10	570000	219759.7
11	570000	199781.5
12	570000	181619.6
13	570000	165108.7
14	570000	150098.8
15	570000	136453.5
16	570000	124048.6
17	570000	112771.5
18	570000	102519.5
19	570000	93199.6
20	570000	84726.9
Net Present Value		9852731.3	(SUM OF DISCOUNTED CASHFLOWS)	SUM(C2:C22)

We can use 20 year bond rate(10%) as the discount rate as it is matching with the tenure of the project and it is also the current rate for a 20 year bond. Net Present Value is calculated using the present interest rate not based on what it would be in future. As expected Net Present Value is negative, Micron shouldn't accept this project.