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Elton Cranes is considering production of a new type of crane. The initial cost of the...

Elton Cranes is considering production of a new type of crane. The initial cost of the project is $23 million.

There is a 50% probability that demand will be strong, in which case the company will gain annual cash flows from assets of $6 million per year for 15 years. Otherwise, the annual cash flows from assets will only be $2 million per year.

The company has a weighted average cost of capital of 9%.

Part 1: What is the NPV of the project (in $ million)

Part 2: Now assume that the company can wait a year to test the demand for the new type of crane. The test costs $0.2 million and will reveal if demand will be strong or weak. If the company accepts the project after one year, the magnitude of the cash flows will be the same, but the cash inflows will occur only for 14 years.

What is the NPV of the project with the option to delay (in $ million)?

Solutions

Expert Solution

Part 1: NPV of the Project
Scenario Probability Annual Cash flow($ million) (Probability)*Cash flow
Strong Demand 0.5 $6 $3
Weak Demand 0.5 $2 $1
SUM $4
Pmt Expected annual cash inflow ($ million) $4
Nper Number of years of cash flow 15
Rate Average Cost of Capital 9%
PV Present Value of Cash inflows $32.24 (Using PV function of excel with Rate=9%, Nper=15, Pmt=-4)
I Initial cash flow ($ million) ($23)
NPV=PV+I Net Present value (NPV) of the project $9.24 million
Part 2
I1 Cost of Test in year 0 ($ million) ($0.20)
Possible outcomes: Probability
Demand will be revealed strong 0.5
Demand will be revealed weak 0.5
If Demand will be weak,the company will not incur further expenses
If Demand will be strong,the company will make the investment
If Demand is strong Future cash flows:
Pmt Expected annual cash inflow ($ million) $6
Nper Number of years of cash flow 14
Rate Average Cost of Capital 9%
PV Present Value of Cash inflows $46.72 (Using PV function of excel with Rate=9%, Nper=15, Pmt=-6)
I Initial cash flow ($ million) ($23)
NPV=PV+i NPV in year 1 $23.72
YEAR 1 outcomes: Probability NPV of project (Probability)*NPV
Demand revealed strong 0.5 $23.72 $11.86
Demand revealed weak 0.5 $0 $0.00
SUM $11.86
Expected NPV in year 1 $11.86
PV1 Present Value of Cash inflows $10.88 (11.86/1.09)
NPV1=PV1+I1 Net Present value (NPV) of the project $10.68 (10.88-0.2)
NPV of the project with option to delay $10.68 million

jeff jeffy answered 1 year ago
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