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1. You need to decide whether to invest in a new product development project. The development phase of the project (years 1-3) will require significant

1. You need to decide whether to invest in a new product development project. The development phase of the project (years 1-3) will require significant investments, leading to projected cash flows in the 10 succeeding years (years 4-13). The net cash flows in each year are as follows (in $US mln.): Year: 1 2 3 4 5 6 7 8 9 10 11 12 13 CF: -5 -50 -60 10 15 25 30 30 28 25 20 10 5 Note that you can assume that all of these cash flows occur at the end of a year, i.e. the first cash flow of -5 occurs at the end of the first year of the project. The positive cash flows in years 4-13 assume a normal market outcome. There is a 50% chance of this normal market outcome, and another 50% chance of a really positive market outcome, where cash flows are twice as high in years 4-13 as recorded above. The interest rate for this high risk project is assumed to be 20%. Calculate the Net Present Value of the Project

2. If (and only if) the market outcome is really positive, you can release a follow up version of the product. Assume that you can represent this follow up project by adding a cash flow into year 14 equal to the net present value of the project in year 0 under the assumption that the market outcome is really positive, i.e. calculate NPV for the really positive outcome alone this value becomes your year 14 cash flow for the really positive option in this new scenario. How does this change your valuation of the project? Show your work & have the proper currency units on your final answer.

3. You can run a market study at the end of year 1 (immediately after the initial $5M investment) which provides you with more information about the market outcome. The study costs $4 million, and is 90% accurate, i.e. if the study shows a really positive market, there is a 90% chance that this is the case (and a 10% chance that the market outcome is just normal). How does the study change the project valuation? Should you run the study? Show your work. (Note: Use your valuation from question 2 here, where you assume that a future generation product exists; you should show whether (a) you would proceed or abandon the project conditional on the outcome of the study, (b) whether you run the study at all, and (c) whether you would invest in the project, given that you can run the study)

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