Question
5 (a). A firm is considering a project that requires an initial investment of $500,000. The project will last for three years. If demand for
5 (a). A firm is considering a project that requires an initial investment of $500,000. The project will last for three years. If demand for the product turns out to be strong, future cash flows are expected to be $260,000 per year; if weak, future cash flows are expected to be only $120,000 per year. Each outcome has a 50% probability. If the cost of capital for this project is 11%, what is the NPV of this project? Should you undertake it? (2 points)
5(b). Suppose that you have an option to delay for one year, and just produce two years if demand is strong. What is the value of this option? What should you do? (2 points)
5(c). Suppose that by investing $510,000 instead of $500,000 you will obtain the flexibility to switch to a different product if demand turns out to be weak. This will give you expected cash flows of $250,000 in years 2 and 3. What is the value of this option? (2 points)
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