In: Finance
Companies often need to choose between making an investment now or waiting until the company can gather more relevant information about the potential project. This opportunity to wait before making the decision is called the investment timing option.
Consider the case:
Tolbotics Inc. is considering a three-year project that will require an initial investment of $43,500. If market demand is strong, Tolbotics Inc. thinks that the project will generate cash flows of $28,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,000 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.
If the company uses a project cost of capital of 12%, what will be the expected net present value (NPV) of this project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)
A.) -$7,669
B.) -$8,880
C.) -$6,458
D.) -$8,073
Tolbotics Inc. has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.
What will be the expected NPV if Tolbotics Inc. delays starting the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)
A.) $2,083
B.) $2,500
C.) $1,875
D.) $10,156
What is the value of Tolbotics Inc.’s option to delay the start of the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)
A.) $1,875
B.) $10,156
C.) $2,500
D.) $2,083
1) Initial Investmet = 43,500 | Strong demand Cashflow = 28,500 | Weak Demand Cashflow = 1,000
Cost of Capital = 12% | Probability of each state = 50% | Time = 3 years
Expected Cashflow each year = Probability * Strong demand Cashflow + Probability * Weak Demand Cashflow
Expected Cashflow each year = 50% * 28,500 + 50% * 1,000 = $14,750
Now we will find PV of all three cashflows using Annuity formula
PV of Annuity = (CF/R)*(1 - (1+R)-T)
PV of Cashflows = (14750/12%)*(1-(1+12%)-3)
PV of Cashflows = $35,427
NPV = PV of cashflows - Initial Investment = 35,427 - 43,500
NPV of the project = - $8,073
Hence, NPV of the project is - 8,073 dollars, which is the Option D.
2) As the company will wait for one year to find the demand, hence, it will lose out on one year's cashflow making it 2 years project
Hence, NPV of the project will be calculated using only the Strong demand cashflows, because if demand is weak, then you wouldn't go for the project.
Cashflow for Strong Demand = 28,500 | Time = 2 years | R = 12%
PV of Cashflows at Year 1 = 28,500 / (1+12%) + 28,500 / (1+12%)2
PV of Cashflows at Year 1 = 48,166.45
NPV at Year 1 = 48,166.45 - 43,500 = 4,666.45
As there is 50% chance that there will be Strong Demand, hence, Expected NPV will be 50% of Strong Demand NPV at year 1 discounted by 12% to Year 0 for final NPV of the project if started after delay.
NPV of the project = (50% * 4,666.45)/(1+12%)
NPV of the project = 2,333.23 / 1.12 = 2,083.24 or 2,083
Hence, NPV of the project if started after delay is $ 2,083, which is Option A.
3) Value of the delay Option = Expected NPV if started after delay - NPV if project not delayed
Value of the delay Option = 2,083 - (-8,073) = $ 10,156
Hence, value of the delay Option is $ 10,156 which is Option B.