Question

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)?

Answer 1

		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