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?

Answer 1

	a)	Present Value(PV) of cash flow
		(Cash flow)/((1+i)^t)
		i=discount rate=WACC=10%=0.1
		t=Year of cash flow
	t	Year	0	1	2	3
	a	Initial Cash Flow	($20,000,000)
	b	After tax cash flow		$7,500,000	$7,500,000	$7,500,000
	c=a+b	Net Cash Flow	($20,000,000)	$7,500,000	$7,500,000	$7,500,000	SUM
	Pv=c/(1.1^t)	Present Value of net cash flow	($20,000,000)	$6,818,182	$6,198,347	$5,634,861	($1,348,610)
		Net Present Value	($1,348,610)
	b)	If they go ahead today:
		Expected annual cash flow	$7,500,000	(50%*10+50%*5)million
		Expected Net Present Value	($1,348,610)
		If they Wait for one Year;
		Yearwise Cash Flow
	t	Year	1	2	3	4
	a	Initial Cash Flow	($20,000,000)
	b	After tax cash flow		$10,000,000	$10,000,000	$10,000,000
	c=a+b	Net Cash Flow	($20,000,000)	$10,000,000	$10,000,000	$10,000,000	SUM
	Pv=c/(1.1^t)	Present Value of net cash flow	($18,181,818)	$8,264,463	$7,513,148	$6,830,135	$4,425,927
		Net Present Value	$4,425,927
		Expected Net Present Value	$2,212,964	(50%*4425927+50%*0)
		Expected Net Present Value is Positive
		Company should Wait for more information