4) 25% A) Using the following information, Compute NPV if we proceed TODAY as if there...

4) 25%	A)	Using the following information, Compute NPV if we proceed *TODAY as if there is no option*
	B)	Using the real option methodology of ch. 26, should Bert wait a year if they will *"know"* which cash flow will occur? Compute NPV of waiting! *Use WACC to discount ALL cash flows!! Should we "wait" or proceed "now"??*

		Bert is considering purchase =	$ 18,000	20	= Years project will go on
		Net Cash Flows =	$ 2,950	11%	= WACC

		If wait one year --
		Purchase price =	$ 17,000

		high cash flow =	$ 3,750
		Chance of high cash flow =	60%
		Low cash flow =	$ 1,700

Expert Solution

1- no option

WACC	11%
Project life	20
PV	-18000
PMT	2950
NPV (using Excel function)	=PV(11%,20,-2950,0,0)-18000
	$5,491.82

NPV using cash flows-
Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
Cash flows	$(18,000.00)	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00	$ 2,950.00
PV	$(18,000.00)	$ 2,657.66	$ 2,394.29	$ 2,157.01	$ 1,943.26	$ 1,750.68	$ 1,577.19	$ 1,420.89	$ 1,280.08	$ 1,153.23	$ 1,038.94	$ 935.99	$ 843.23	$ 759.67	$ 684.38	$ 616.56	$ 555.46	$ 500.42	$ 450.83	$ 406.15	$ 365.90
NPV	$ 5,491.82

2- evaluating option
High cash flow
NPV (using Excel function)	=(PV(11%,19,-3750,0,0)-17000)/(1+11%)^1
	$11,168.79

Low cash flow
NPV (using Excel function)	=(PV(11%,19,-1700,0,0)-17000)/(1+11%)^1
	-$3,309.19

NPV using cash flows (high)-
Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
Cash flows	$ -	$(17,000.00)	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00	$ 3,750.00
PV	$ -	$(15,315.32)	$ 3,043.58	$ 2,741.97	$ 2,470.24	$ 2,225.44	$ 2,004.90	$ 1,806.22	$ 1,627.22	$ 1,465.97	$ 1,320.69	$ 1,189.81	$ 1,071.90	$ 965.68	$ 869.98	$ 783.77	$ 706.10	$ 636.12	$ 573.08	$ 516.29	$ 465.13
NPV	$ 11,168.79

NPV using cash flows (low)-
Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
Cash flows	$ -	$(17,000.00)	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00	$ 1,700.00
PV	$ -	$(15,315.32)	$ 1,379.76	$ 1,243.03	$ 1,119.84	$ 1,008.87	$ 908.89	$ 818.82	$ 737.68	$ 664.57	$ 598.71	$ 539.38	$ 485.93	$ 437.77	$ 394.39	$ 355.31	$ 320.10	$ 288.38	$ 259.80	$ 234.05	$ 210.86
NPV	$ (3,309.19)

Chances of high cash flow	60%
Chances of low cash flow	40%
Probability weighted cash flow
=60%11168.79+40%-3309.19	5,377.60

NPV of waiting

(114.22)

As we can see, the probable cash flows from waiting are lower than those from starting today. Hence, it is advisabel to invest today and not take the option.

jeff jeffy answered 1 year ago

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