Question

Firm C is considering a project with an up-front cost at t = 0 of $1500. (All dollars in this problem are in thousands.) The project’s subsequent cash flows are critically dependent on whether a competitor’s product is approved by the Food and Drug Administration (FDA). If the FDA rejects the competitive product, C’s product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact company C. There is a 75% chance that the competitive product will be rejected, in which case the expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor’s product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). Company C will know for sure one year from today whether the competitor’s product has been approved. Company C is considering whether to make the investment today or to wait a year to find out about the FDA’s decision. If it waits a year, the project’s up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor’s product is rejected and $25 per year if the alternative product is approved. However, if company C decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7). Assuming that all cash flows are discounted at 10%, if Firm C chooses to wait a year before proceeding, how much will this increase or decrease the project’s expected NPV in today’s dollars (i.e., at t = 0), relative to the NPV if it proceeds today

Answer 1

		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate =10%=0.10
		N=Year   of Cash Flow
		NPV if FIRM C PROCEEDS TODAY
		Expected annual cash flow=75%*500+25%*25	$381.25
			$0
	N	Year	0	1	2	3	4	5	6	7
	a	Initial cash flow	-$1,500
	b	Expected annual cash flow		$381	$381	$381	$381	$381	$381	$381
	CF=a+b	Net Cash Flow	-$1,500	$381	$381	$381	$381	$381	$381	$381	SUM
	PV=CF/(1.10^N)	Present Value of Cash Flow	-$1,500	$346.591	$315.083	$286.439	$260.399	$236.726	$215.206	$195.642	$356.085
	NPV=Sum of PV	Expected Net Present Value	$356.085
		NPV IF FIRM C CHOOSES TO WAIT A YEAR BEFORE PROCEEDING
	N	Year	0	1	2	3	4	5	6	7
	a	Initial cash flow		-1500
	b	Annual After tax Maintenance=15000*0.35			$500	$500	$500	$500	$500	$500
	CF=a+b	Net Cash Flow		-$1,500	$500	$500	$500	$500	$500	$500	SUM
	PV=CF/(1.1^N)	Present Value of Cash Flow	$0	-$1,363.636	$413.223	$375.657	$341.507	$310.461	$282.237	$256.579	$616.028
	NPV=Sum of PV	Net Present Value	$616.028
		INCREASE IN EXPECTED NPV IN TODAY'S DOLLAR($000)	$259.943	(616.028-356.085)
		INCREASE IN EXPECTED NPV IN TODAY'S DOLLAR	$259,943