Old Exam Questions - Capital Budgeting - Solutions
Page 12 of 96 Pages
7.
Your company is thinking about taking on an investment project that will require an
initial outlay of $2,000,000 at time period zero. You believe that this project will
produce expected after-tax cash flows of $480,000 each year for 6 years (Years 1-6).
Given a cost of capital for this project of 8 percent, you can calculate that the expected
NPV for this project is $218,982.24 and its IRR is 11.53 percent.
Assume now that the firm has the option of delaying the start of this project for 1 year.
If they delay the project its cost at Year 1 will increase to $2,250,000. The firm will
also have better information about what the cash flows will actually be in Years 2-7
(still a 6-year project). Specifically, there is a 50 percent probability that the cash flow
will be $280,000, and a 50 percent chance that the cash flow would be $680,000.
Ignoring option pricing, what is the incremental NPV that will arise, as of time period
zero, if the firm delays implementation of this project for 1 year?
*
As of Time Period 1
:
NPV
CF Option 1
= -$2,250,000 + [$280,000][PVIFA
8%,6
] = - $955,593.69
(will not take on project)
NPV
CF Option 2
= -$2,250,000 + [$680,000][PVIFA
8%,6
] = $893,558.17
(will take on project)
Expected NPV if Delayed = (.50)($0.00) + (.50)($893,558.17) = $446,779.09
As of Time Period 0
:
Expected NPV if Delayed = ($446,779.09) / (1.08) = $413,684.34
Incremental NPV = $413,684.34 - $218,982.24 = $194,702.10
8.
The cash flows associated with a project can be represented by the following decision
tree (conditional probabilities are in parentheses):
Year 0
Year 1
Year 2
Year 3
$ 0 (.5)
$100 (.5)
$200 (.5)
$200 (.5)
$200 (.5)
$300 (.5)
$400 (.5)
-$400