Question

1. The Waterhouse Group is considering whether to go ahead with a small-scale trial project that requires an initial outlay of $1,440,000 and, if successful produce cash inflows of $720,000 in year one followed by $864,000 per year in perpetuity starting at the end of year two. If not successful, the project will produce no cash flows. The probability of success is 38%. Given the extreme riskiness of this project the company decides to use 30% as a risk-adjusted discount rate for this project.
   1. Given the above information and based on static analysis, should the company go ahead with its investment?
   2. Upon further study the company realizes that, if the project was successful, it creates an opportunity to expand production by investing an additional $14,400,000 at the end of year one. The new investment would increase the project cash flows to $3,520,00 (instead of $864,000) per year in perpetuity. Also, at that point the company feels that a major part of the risk associated with the project would have been resolved and that from year one on it can use its normal RRR (aka WACC) of 16%. Given this information, should the company go ahead with the investment?
   3. What is the present value of the option to expand?  

Please show all calculations clearly and draw decision trees where necessary.

Answer 1

a.Given the above information and based on static analysis, should the company go ahead with its investment?

Probability of success=38%=0.38

Discount Rate =30%=0.30

If Successful

Present Value of Year 1 cash inflow=720000/1.3=$553,846

Value in  Year 1 of cash inflow in perpetuity=864000/0.3=$2,880,000

Present Value today of cash finflow in perpetuity=2880000/1.3=$2,215,385

Total Present Value of Cash inflow if successful=553846+2215385=$2,769,381

If Not successful,

Probability=1-0.38=0.62

Total Present Value of cash inflow=$0

Expected Present Value of Cash Inflow=0.38*2769381+0.62*0=$1,052,308

Net Present Value of the Project =1052308-1440000=-$387,692

THE COMPANY SHOULD NOT GO AHEAD WITH THE INVESTMENT.

NPV IS NEGATIVE

b. Additional Investment in Year 1, if successful =$1,440,000

Value in year 1 of cash inflow in perpetuity=3520000/0.16=$22,000,000

Net Value of Cash Inflow in Year 1, if investment is made =22000000-1440000=$20,560,000

Present Value of Cash inflow in perpetuity =20560000/1.3=$15,815,385

Net Present Value =0.38*($15,815,385+$553,846)-$1,440,000=$4780308

The Company SHOULD GO AHEAD WITH THE INVESTMENT

NPV IS POSITIVE

c. Value of Option to expand=4780308+387692=$5,168,000