fm13 16 - expected NPV of $4.61 million but implementing...

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Mini Case: 13 - 16 e. Use decision tree analysis to calculate the NPV of the project with the investment timing option. Answer: The project will be implemented only if demand is average or high. Here is the time line: 0 1 2 3 4 High $0 -$70 $45 $45 $45 Average $0 -$70 $30 $30 $30 Low $0 $0 $0 $0 $0 To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is known for certain, and discount the other risky cash flows at the 10 percent cost of capital. High: NPV = -$70/1.06 + $45/1.10 2 + $45/1.10 3 +$45/1.10 4 = $35.70 Average: NPV = -$70/1.06 + $30/1.10 2 + $30/1.10 3 +$30/1.10 4 = $1.79 Low: NPV = $0. Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42. Since this is much greater than the NPV of immediate implementation (which is $4.61 million) we should wait. In other words, implementing immediately gives an
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Unformatted text preview: expected NPV of $4.61 million, but implementing immediately means we give up the option to wait, which is worth $11.42 million. f. Use a financial option pricing model to estimate the value of the investment timing option. Answer: The option to wait resembles a financial call option-- we get to “buy” the project for $70 million in one year if value of project in one year is greater than $70 million. This is like a call option with a strike price of $70 million and an expiration date of one year. X = Strike Price = Cost Of Implement Project = $70 Million. R RF = Risk-Free Rate = 6%. T = Time To Maturity = 1 year. P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows. σ 2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return....
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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