Investment Timing Option: Decision-Tree Analysis

Wansley Lumber is considering the purchase of a paper company which would require an initial investment of $300 million. Wansley estimates that the paper company would provide net cash flows of $40 million at the end of each of the next 20 years. The cost of capital for the paper company is 13%.

Should Wansley purchase the paper company? (Answers: Yes or No)

Wansley realizes that the cash flows in Years 1 to 20 might be $31 million per year or $49 million per year, with a 50% probability of each outcome. Because of the nature of the purchase contract, Wansley can sell the company 2 years after purchase (at Year 2 in this case) for $285 million if it no longer wants to own it. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? Again, assume that all cash flows are discounted at 13%. (Answers: Yes or No)

Wansley can wait for 1 year and find out whether the cash flows will be $31 million per year or $49 million per year before deciding to purchase the company. If so, when? Because of the nature of the purchase contract, if it waits and purchases, Wansley can no longer sell the company 2 years after purchase. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? Again, assume that all cash flows are discounted at 13%. (Answers: It doesn't make sense to purchase the paper company; Yes, it makes sense to purchase the paper company today; No, it makes sense to wait one year before deciding whether to make the acquisition)