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1/10/2007
Chapter 13.
Solution to Ch 139 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
Riskfree 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.
 Summer '09
 J.Marsh

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