Page 1
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.
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 Summer '09
 J.Marsh
 Net Present Value, Operating cash flow, decision tree analysis

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