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Solution to FM12 Ch 13 P09 Build a Model

Solution to FM12 Ch 13 P09 Build a Model - Chapter 13...

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Page 1 1/10/2007 Chapter 13. Solution to Ch 13-9 Build a Model a. Find the project's expected cash flows and NPV. WACC= 12% Condition Probability CF CF x Prob. Good 30% $9 $2.70 Medium 40% $4 $1.60 Bad 30% -$1 -$0.30 Expected CF= $4.00 Time line of Expected CF 0 1 2 3 -$10 $4.00 $4.00 $4.00 NPV= -$0.39 Without any real options, reject the project. It has a negative NPV and is quite risky. WACC= 12% Salvage Value = $6 Risk-free rate = 6% Decision Tree Analysis Cost Future Cash Flows NPV this Probability 0 Probability 1 2 3 Scenario x NPV $9 $9 $9 $11.62 $3.48 30% -$10 40% $4 $4 $4 -$0.39 -$0.16 30% $5 $0 $0 -$5.54 -$1.66 Expected NPV of Future CFs = $1.67 Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30 percent probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years. There is a 40 percent probability of medium conditions, in which case the annual cash flows will be $4 million, and there is a 30 percent probability of bad conditions and a cash flow of -$1 million per year. BSI uses a 12 percent cost of capital to evaluate projects like this. b. Now suppose the BSI can abandon the project at the end of the first year by selling it for $6 million. BSI will still receive the Year 1 cash flows, but will receive no cash flows in subsequent years. Assume the salvage value is risky and should be discounted at the WACC.
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