Question

a. Project X has an up-front cost of $20 million. The project is expected to produce after-tax cash flows of $7.5 million at the end of each of the next 3 years (t = 1, 2, and 3). The project has a WACC=10%. What is the project’s NPV? b. However, if the company waits a year they will find out more about the project’s expected cash flows. If they wait a year, there is a 50% chance the market will be strong and the expected cash flows will be $10 million a year for 3 years. There is also a 50% chance the market will be weak and the expected cash flows will be $5 million a year for 3 years. The project’s initial cost will remain $20 million, but it will be incurred at t = 1 only if it makes sense at that time to proceed with the project. So, should the company go ahead with the project today or wait for more information? Wait 1 year; cash flows are shown as below in millions on time line:

                                   0             1             2             3             4                        

Strong demand                    |              |              |              |              |             

50% Prob.                          0            -20           10            10            10                     

Weak demand                     |              |              |              |              |             

50% Prob.         0          -20       5          5          5

Answer 1

Part a)

WACC	10%
Project X	Year 0	Year 1	Year 2	Year 3
After undiscounted Cashflows	-20	7.5	7.5	7.5
Present Value of Cashflows	-20	6.8	6.2	5.6
NPV of Project X	-$1,348,610.07

PV = CF/(1+WACC)^n

CF = -20, 7.5, 7.5, 7.5

WACC = 10%

n = 0,1,2,3

NPV = -$1,348,610.07

Part b) Based on the given information, NPV of delaying the project can be calculated as follows:

WACC	10%
Project X	Probability	Year 0	Year 1	Year 2	Year 3	Year 4
After tax Cashflows - Strong Demand	50%	0	-20.00	10.00	10.00	10.00
After tax Cashflows - Weak Demand	50%	0	-20.00	5.00	5.00	5.00
Probability Adjusted Cashflows (Undiscounted)		0	-20.00	7.50	7.50	7.50
Present Value of Cashflows		0	-18.18	6.20	5.63	5.12
NPV of Project X	-$1,226,009.15

Although the expected cashflows are the same in both the scenario, NPV is higher in the scenario of delaying the project by 1 year due to time value of money. (delayed investment of $20 Mn)

The company should wait for 1 year and gather more information.