Question

When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2009, and the equipment necessary for producing the containers was being sold for $900K. Each year, this cost is expected to increase by 20%. The useful life of the equipment and the project is 5 years. Mr. Johnson estimated that during a good year, the project will generate net cash flows of $700K per year, while during a bad year, the project will lose money, with an expected net cash flow of

$-300K per year.

Because the economy suffered a significant decline just a year prior, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that uncertainty will remain in 2010 and at this point, in 2009, the likelihood of 2010 being a good year is estimated at 40% and the likelihood of 2010 being a bad year is estimated at 60%. However, all uncertainty will get resolved in 2011. The likelihood of 2011 and all subsequent years being good years (recovery) is 60%, and the likelihood of these subsequent years being bad years (recession) is 40%.

Since he has not dealt with uncertainty regarding the future state of the economy before, Mr. Johnson is bewildered and asks your help in determining the course of action regarding this opportunity. Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%.

What is the NPV of investing into the machine in 2009? A: $1109.1

What is the NPV (in year 2009) of delaying the investment until 2010? __________________

Should the firm invest in the project in 2009, 2010, or not invest at all? __________________

Assume that the firm has the possibility to invest in 2009 only. What is the value of knowing in 2009 with certainty the state of the world in 2010, with regards to this project? In other words, what is the maximum amount of money the company would pay to know in 2009 whether 2010 would be a good or a bad year? Explain your answer.

Answer 1

1. NPV in Year 2009:

Particulars	2009	2010	2011	2012	2013	2015
Container Cost	(900,000.00)
Good Year		700,000.00	700,000.00	700,000.00	700,000.00	700,000.00
Probability		0.40	0.60	0.60	0.60	0.60
Bad Year		(300,000.00)	(300,000.00)	(300,000.00)	(300,000.00)	(300,000.00)
Probability		0.60	0.40	0.40	0.40	0.40
Estimated Cash Flows		100,000.00	300,000.00	300,000.00	300,000.00	300,000.00
Discount Rate	1	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323
PV of cash flows	(900,000.00)	90,909.09	247,933.88	225,394.44	204,904.04	186,276.40
NPV	55,417.85

2. NPV in 2010

Particulars	2009	2010	2011	2012	2013	2015	2016
Container Cost		(1,080,000.00)
Good Year			700,000.00	700,000.00	700,000.00	700,000.00	700,000.00
Prob			0.60	0.60	0.60	0.60	0.60
Bad Year			(300,000.00)	(300,000.00)	(300,000.00)	(300,000.00)	(300,000.00)
Prob			0.40	0.40	0.40	0.40	0.40
Estimated Cash Flows			300,000.00	300,000.00	300,000.00	300,000.00	300,000.00
Discount Rate	1	0.909090909	0.826446281	0.751314801	0.683013455	0.620921323	0.56447393
PV of cash flows	-	(981,818.18)	247,933.88	225,394.44	204,904.04	186,276.40	169,342.18
NPV	52,032.76

3. Since NPV is positive, so firm should invest in the project in 2009

4. Cost of knowing whether 2010 will be a good or bad year will be the decrease in NPV in 2010 as compared from 2009 i.e. $3,385