Problem Set 3

# Problem Set 3 - FI 311H- Financial Management - Professor...

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FI 311H- Financial Management - Professor Hadlock Problem Set #3 Due by 5:00 p.m. October 11th Chapter 8 Problems #1. A firm is considering producing and selling a new product. The initial investment is \$9.9 million. If the product is a success, one year after the initial investment the product will generate an annual cash flow of \$2,000,000 in perpetuity with the first cash flow arriving one year after the investment. If the product is not a success, the initial investment will generate an annual cash flow of \$0 in perpetuity. Managers only learn if the product is a success if they make this \$9.9 million initial investment. The initial investment has no salvage value. The probability that the product is a success is 50%. However, by spending one year test- marketing the product before making the investment, the firm believes they can raise the probability of success to 75%. The test marketing will cost \$4,000,000. To be clear, if the firm conducts the test marketing at date 0 and spends \$4,000,000, then at date 1 they can decide to invest in the project after the test marketing is complete. In this event, if they choose to invest at date 1, they anticipate that there will now be a 75% chance of success, in which case the project will generate an annual cash flow of \$2,000,000 each year starting at date 2. If the project is not

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## This note was uploaded on 10/17/2011 for the course ECON 101 taught by Professor Thompson during the Spring '11 term at Michigan State University.

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Problem Set 3 - FI 311H- Financial Management - Professor...

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