Solution to FM12 Ch 13 P09 Build a Model

Solution to FM12 Ch 13 P09 Build a Model - 1/10/2007...

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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. When abandonment is factored in, the very large negative NPV under bad conditions is reduced, and the expected NPV
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This note was uploaded on 08/01/2009 for the course FI FI504 taught by Professor J.marsh during the Summer '09 term at DeVry Chicago.

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Solution to FM12 Ch 13 P09 Build a Model - 1/10/2007...

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