Practice Problem 1 - Timing option

PROBLEM 1.

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

1. Should Hart purchase the paper company?
2. Harts best guess is that cash flows will be $40 million a year, but it realizes that the cash flows are as likely to be $30 million a year or $50 million. In addition, Hart could sell the paper company at Year 3 for $280 million. 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%.