Question

QUESTION 10

1. ABC Inc. is evaluating an investment project that lasts for three years. The project has the cost of capital of 10% and requires an initial investment of $3 million. There is a 60% chance that the project would be successful and would generate annual free cash flows of $2 million per year during the next three years. There is a 40% chance that the project would be less successful and would generate only $1 million per year during the next three years. However, ABC recognizes that if the project is successful, it could invest $2 million at the end of the second year to expand the project and receive a free cash flow of $4 at the end of the third year. ABC estimates that the net project value (NPV) of the project without the option to expand and the NPV of the project with the option to expand would be closest to:

   	A.	The NPV of the project without the option to expand is $1.97 million and the NPV of the project with the option to expand is $3.33 million
   	B.	The NPV of the project without the option to expand is $0.98 million and the NPV of the project with the option to expand is $1.79 million
   	C.	The NPV of the project without the option to expand is -$0.51 million and the NPV of the project with the option to expand is $0.81million
   	D.	The NPV of the project without the option to expand is -$0.51 million and the NPV of the project with the option to expand is $1.97 million

Answer 1

Expected cash flow = probability of success * Cash flow in success + probability of Failur * Cash flow in Failure = $1.60 Million

Option D is the answer. The NPV of the project without the option to expand is $0.98 million and the NPV of the project with the option to expand is $1.79 million

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