You have been retained to evaluate a major investment for a technology company. The cost of the project is $100 million. If the project is successful, it will generate expected profits of $15 million per year forever, which has a present value of $150 million. However, there is a 50% chance that the project will be a complete failure, in which case it will generate no cash flows. If the project is successful, there will be a follow-on project that can be initiated the following year. The follow-on project will have a cost of $1 billion, and if all goes well (probability of 50%), it will generate expected cash flows of $150 million per year that will last forever and will result in a value of $1.5 billion (in year 1 dollars). If the follow-on project is not successful, it will result in a stream of cash flows with a present value of $900 million. Should the initial project be undertaken? Explain your recommendation in commonsense terms to your boss, who is not a technology person.

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PROBLEM 13-5

First Project

Year 1

Year 2

Year 3

PV (good state)

150

15

15

15

prob = 50%

Investment

-100

prob = 50%

PV (bad state)

0

0

0

0

NPV

Follow-On Opportunity (Year 1)

Year 2

Year 3

Year 4

PV

1500

150

150

150

prob = 50%

Investment

-1000

prob = 50%

PV

900

90

90

NPV