In: Accounting
Practice Problem 1 - Timing option
PROBLEM 1.
Hart Lumber is considering the purchase of a...
Practice Problem 1 - Timing option
PROBLEM 1.
Hart Lumber is considering the purchase of a paper company,
which would require an initial investment of $300 million. Hart
estimates that the paper company would provide net cash flows of
$40 million at the end of the next 20 years. The cost of capital
for the paper company is 13%.
- Should Hart purchase the paper company?
- Hart’s best guess is that cash flows will be $40 million a
year, but it realizes that the cash flows are as likely to be $30
million a year or $50 million. In addition, Hart could sell the
paper company at Year 3 for $280 million. Given this additional
information, does decision-tree analysis indicate that it makes
sense to purchase the paper company? Again, assume that all cash
flows are discounted at 13%.