AMC Corp. is considering launching a new product but there is some uncertainty about how the oroduct will be received by consumers. Your junior analyst has provided you with three scenarios of possible market conditions and estimated the probability of each scenario. Starting the project oday (t=0) would incur costs of $12,000,000, the cost of capital is 11%, you can ignore taxes. The three scenarios are as follows: - "Good": The product is very popular and operating profits are estimated to start at $1,100,000 in year 1(t=1) and afterwards will grow at 7% forever. The probability of this scenario is 30%. - "Average": Year 1 operating profits (cash flow at t=1 ) are $1,100,000 and grow at 4% in perpetuity. The probability of this scenario is 55%. - "Poor": Year 1 operating profits are $800,000 but decline by 10% each year. The probability of this scenario is 15%. a) What is the NPV of this project? Hint: i. First, calculate the NPV of the project for each scenario individually (i.e., good, average, poor). ii. Then, calculate a weighted average of the three scenarios using the probabilities provided in the question. b) Suppose AMC can hire consultants to do additional market research to determine how consumers will receive the product. The research will take one year (i.e. the project cash flows would start one year later). With this research, AMC will know exactly which of the three scenarios is accurate and there would be no uncertainty about the project's outcome before investing at the end of the first year. What is the project's NPV today in this case? (Hint: Think about in which scenarios AMC would decide to go forward with the project.) c) What is the maximum AMC Corp. would be willing to pay for conducting this additional market research? (Hint: find the value of the "option to wait" for one year.) d) Without doing any calculations, if the probabilities of the "good", "average", and "poor" scenario were 40%,35%, and 25% instead, respectively, would you expect the value of the option to conduct additional research to be higher, lower, or unchanged? Explain. AMC Corp. is considering launching a new product but there is some uncertainty about how the oroduct will be received by consumers. Your junior analyst has provided you with three scenarios of possible market conditions and estimated the probability of each scenario. Starting the project oday (t=0) would incur costs of $12,000,000, the cost of capital is 11%, you can ignore taxes. The three scenarios are as follows: - "Good": The product is very popular and operating profits are estimated to start at $1,100,000 in year 1(t=1) and afterwards will grow at 7% forever. The probability of this scenario is 30%. - "Average": Year 1 operating profits (cash flow at t=1 ) are $1,100,000 and grow at 4% in perpetuity. The probability of this scenario is 55%. - "Poor": Year 1 operating profits are $800,000 but decline by 10% each year. The probability of this scenario is 15%. a) What is the NPV of this project? Hint: i. First, calculate the NPV of the project for each scenario individually (i.e., good, average, poor). ii. Then, calculate a weighted average of the three scenarios using the probabilities provided in the question. b) Suppose AMC can hire consultants to do additional market research to determine how consumers will receive the product. The research will take one year (i.e. the project cash flows would start one year later). With this research, AMC will know exactly which of the three scenarios is accurate and there would be no uncertainty about the project's outcome before investing at the end of the first year. What is the project's NPV today in this case? (Hint: Think about in which scenarios AMC would decide to go forward with the project.) c) What is the maximum AMC Corp. would be willing to pay for conducting this additional market research? (Hint: find the value of the "option to wait" for one year.) d) Without doing any calculations, if the probabilities of the "good", "average", and "poor" scenario were 40%,35%, and 25% instead, respectively, would you expect the value of the option to conduct additional research to be higher, lower, or unchanged? Explain
