Question

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: St. Margaret Beer Co. is considering a three-year project that will require an initial investment of $42,500. If market demand is strong, St. Margaret Beer Co. thinks that the project will generate cash flows of $29,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $2,000 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.)

-$5,605

-$4,204

-$4,671

-$5,138

St. Margaret Beer Co. 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 St. Margaret Beer Co. delays starting the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)

$2,956

$3,284

$7,940

$7,955

What is the value of St. Margaret Beer Co.’s option to delay the start of the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)

$2,956

$7,940

$7,955

$3,284

Answer 1

1. NPV of Project
Year	0	1	2	3
Cost of New Machine	$ (42,500.00)
Cash Inflow		$   15,750.00	$   15,750.00	$   15,750.00
Net Cash Flow	$ (42,500.00)	$   15,750.00	$   15,750.00	$   15,750.00
NPV	$   (4,671)	NPV(0.12,AX5:AZ5)+AW5
	Option C

2.

2. NPV of Project
Year	0	1	2	3
Cost of New Machine		$                           (42,500.00)
Cash Inflow			$ 29,500.00	$ 29,500.00
Net Cash Flow	$                   -	$                           (42,500.00)	$ 29,500.00	$ 29,500.00
PV @ 12%	$              1.00	$                                        0.89	$            0.80	$            0.71
Discounted Cash Flow	$                   -	$                           (37,946.43)	$ 23,517.22	$ 20,997.52
NPV	$            6,568
NPV @ 50%	$            3,284
	Option B

3. Option Value = Delayed NPV - (NPV if started Now) = $3284 - (- 4671) = $7955 Option C