Question

The Z-90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another one of its products, Z-45, becomes an industry standard. There is a 60% chance that the Z-45 will become the industry standard, in whihc case the Z-90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 40% chance that the Z-45 will not become the industry standard, in which case the Z-90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

a. Based on the above information, what is the Z-90's expected net present value and coefficient of variation?

b. Now assume that one year from no SI will know if the Z-45 has become the industry standard, and will only invest in that case. The cash flows will be the same and will still be available for 5 years form the initial investment. Assuming that the cost of capital remains at 12%, what is the estimated value of this investment timing opition? What is the coefficient of variation of the projects cash flows with the option to wait? Is the overall risk of the project reduced with the introduction of the option (Yes/No)?

Answer 1

Year		0		1		2			3				4		5	Total PV
Initial Inv		250,000
Cashflow		Case I		110,000		110,000			110,000				110,000		110,000
Cashflow		Case II		25,000		25,000			25,000				25,000		25,000
		PV		98,214		87,691			78,296				69,907		62,417	396,525
		PV		22,321		19,930			17,795				15,888		14,186	90,119
		Expected NPV		23,963		(.6*case I + .4*Case II) - 250,000
As per the table expected NPV is = $23,963. With the option of delaying the Investment, the company would make the investment only if the cash flow is it becomes the industry standard. The NPV is much higher at $130,826. Yes, the overall risk is much lower with the new option.
	0		1		2			3		4		5		6		Total PV
	Initial Inv		250,000
					110,000			110,000		110,000		110,000		110,000
	PV of Initial Inv		223,214
	PV of cash flow				87,691			78,296		69,907		62,417		55,729		354,041
	NPV		130,826