Assigned Problem 1 NPC is considering either to invest in a project for a new pr
ID: 2658623 • Letter: A
Question
Assigned Problem 1 NPC is considering either to invest in a project for a new product immediately or 1 year later. If NPC invests in the project today, there will be 75% chance of good market acceptance ofthe product and 25% chance of bad market acceptance of the product. If market reaction to the new product is good, a cash inflow of S500 million will be realized each year for the next 7 years. If market reaction to the new product is bad, a cash inflow of $25 million will be realized each year for the next 7 years. However, ifNPC chooses to wait for 1 year to obtain more information about market tastes, the company would know definitely about the market reaction and would then either proceed with the project or not invest in it at all. The initial cost of the project is $1,500 million Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding and the project will still end 7 years from now, how much will this increase or decrease the project's expected NPV in today's dollars (i.e., at t-0), relative to the NPV if it proceeds today? a. b. Using the same data, estimate the effect ofwaiting on the project's risk i.e. calculate by how much the one-year delay will reduce the project's coefficient of variation. (Hint: Use the expected NPV.) Please Show Work...Explanation / Answer
If the project starts today, then the cash flows are as follows:
Year
Good Cash Flows
Probability
Year
Bad Cash Flows
Probability
0
-1500
0
-1500
1
500
0.75
1
25
0.25
2
500
0.75
2
25
0.25
3
500
0.75
3
25
0.25
4
500
0.75
4
25
0.25
5
500
0.75
5
25
0.25
6
500
0.75
6
25
0.25
7
500
0.75
7
25
0.25
Net present value of good cash flows = -1500 + [500/(1.12)] + [500/{(1.12)^2}] + [500/{(1.12)^3}] + [500/{(1.12)^4}] + [500/{(1.12)^ 5}] + [500/{(1.12)^6}] + [500/{(1.12)^7}] = 934.21
Net present value of bad cash flows = -1500 + [25/(1.12)] + [25/{(1.12)^2}] + [25/{(1.12)^3}] + [25/{(1.12)^4}] + [25/{(1.12)^ 5}] + [25/{(1.12)^6}] + [25/{(1.12)^7}] = -1378.29
Therefore, expected NPV = (934.21*0.75) + (-1378.29*0.25) = 356.28
If the project starts next year:
Year
Good Cash Flows
1
-1500
2
500
3
500
4
500
5
500
6
500
7
500
Net present value = [-1500/(1.12)] + [500/{(1.12)^2}] + [500/{(1.12)^3}] + [500/{(1.12)^4}] + [500/{(1.12)^ 5}] + [500/{(1.12)^6}] + [500/{(1.12)^7}] = 616.03
Therefore, difference between the project NPV at two different time periods = 616.03-356.28 = 259.75
So, if the project is taken up next year rather than today, then the expected NPV will increase by 259.75
Year
Good Cash Flows
Probability
Year
Bad Cash Flows
Probability
0
-1500
0
-1500
1
500
0.75
1
25
0.25
2
500
0.75
2
25
0.25
3
500
0.75
3
25
0.25
4
500
0.75
4
25
0.25
5
500
0.75
5
25
0.25
6
500
0.75
6
25
0.25
7
500
0.75
7
25
0.25