4. Investment timing options

Consider this case:

1a. Dernham Inc. is considering a three-year project that will require an initial investment of $43,500. If market demand is strong, Dernham Inc. thinks that the project will generate cash flows of $28,000 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $2,000 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

If the company uses a project cost of capital of 14%, what will be the expected net present value (NPV) of this project?

-$7,375

-$8,676

-$9,544

-$7,808

1b. Dernham Inc. has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.

What will be the expected NPV if Dernham Inc. delays starting the project?

$972

$1,143

$2,286

$21,506

1c. What is the value of Dernham Inc.'s option to delay the start of the project?