Question

ABC Inc. is considering a project that will cost $60 million. The cost of capital for this type of project is 10%, and the risk-free rate is 6%. The project will generate the following cash flows every year for the next two years. Assume that there is a 30% chance of high demand with associated future cash flows of $45 million per year. There is also a 40% chance of average demand with cash flows of $30 million per year as well as a 30% chance of low demand with cash flows of only $15 million per year. Assume that the project has an investment timing option because it can be delayed for a year. The cost will still be $60 million at the end of the year, and the cash flows for the three scenarios will still last 2 years. However, Tropical Sweets will know for sure the level of demand one year from now and implement the project only if the demand is high or average with a positive NPV. Answer the following three questions: 1) What is the NPV of the project without the timing option? 2) What is the NPV of the project with the investment timing option? 3) Should the firm delay the implementation of the project one year?

A. 1) ($7.93); 2) $4.32; 3) Yes

B. 1) $14.61; 2) $12.75; 3) No

C. 1) $4:61; 2) $11.56; 3) Yes

D. 1) ($7.93); 2) $2.22; 3) No

Answer 1

Use spreadsheet for the required computations. Enter values and formulas in the spreadsheet as shown in the image below.

The obtained result is provided below.