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IN CAPITAL
CHAPTER
12 BUDGETING
(Difficulty: E = Easy, M = Medium, and T = Tough)
Diff: E
Which of the following statements best describes the likely impact that an
abandonment option will have on a projects expected cash flow and risk?
a.
b.
c.
d.
e.
Answer: b
Diff: E
Flexibility option
3
Answer: c
Diff: E
Chapter 12 - Page 1
Real options
4
Answer: c
Diff: E
Real options
5
Answer: b
Diff: E
Whalen Maritime Research Inc. regularly takes real options into account
when evaluating its proposed projects.
Specifically, Whalen considers
the option to abandon a project whenever it turns out to be unsuccessful
(the abandonment option). In addition, it usually evaluates whether it
makes sense to invest in a project today or whether to wait to collect
more information (the investment timing option).
Assume the proposed
projects can be abandoned at any time without penalty.
Which of the
following statements is most correct?
a. The abandonment option tends to reduce a projects NPV.
b. The abandonment option tends to reduce a projects risk.
c. If there are important first-mover advantages, this tends to increase
the value of waiting a year to collect more information before
proceeding with a proposed project.
d. Statements a and b are correct.
e. All of the statements above are correct.
Chapter 12 - Page 2
Real options
6
Answer: b
Diff: E
Real options
7
Answer: a
Diff: E
Real options
8
Answer: d
Diff: E
Chapter 12 - Page 3
Answer: d
Diff: E
Medium:
Real options
10
Answer: b
The
The
The
The
The
option
option
option
option
option
Real options
11
Diff: M
Answer: d
Diff: M
Which of the following will not increase the value of a real option?
a. An increase in the time remaining until the real option must be
exercised.
b. An increase in the volatility of the underlying source of risk.
c. An increase in the risk-free rate.
d. An increase in the cost of exercising the real option.
e. Statements b and d.
Answer: a
Diff: M
Chapter 12 - Page 4
Chapter 12 - Page 5
Answer: c
Diff: E
Capital Required
$400 million
300 million
250 million
320 million
230 million
IRR
14.0%
10.7
10.5
10.0
9.0
The company is debating which cost of capital they should use to evaluate
Division Bs projects. John Green argues that Shanahan should use the same
cost of capital for each of its divisions, and believes it should base the
cost of equity on Shanahans overall beta. Becky White argues that the
cost of capital should vary for each division, and that Division Bs beta
should be used to estimate the cost of equity for Division Bs projects.
If the company uses Whites approach, how much larger will the capital
budget be than if it uses Greens approach?
a.
b.
c.
d.
e.
Chapter 12 - Page 6
Replacement chain
.
14
$34,425
$30,283
$29,964
$29,240
$24,537
Replacement chain
.
Diff: E
Jayhawk Jets must choose one of two mutually exclusive projects. Project A
has an up-front cost (t = 0) of $120,000, and it is expected to produce
cash inflows of $80,000 per year at the end of each of the next two years.
Two years from now, the project can be repeated at a higher up-front cost
of $125,000, but the cash inflows will remain the same. Project B has an
up-front cost of $100,000, and it is expected to produce cash inflows of
$41,000 per year at the end of each of the next four years. Project B
cannot be repeated. Both projects have a cost of capital of 10 percent.
Jayhawk wants to select the project that provides the most value over the
next four years. What is the net present value (NPV) of the project that
creates the most value for Jayhawk?
a.
b.
c.
d.
e.
15
Answer: b
Answer: d
Diff: E
$ 677.69
$1,098.89
$1,179.46
$1,237.76
$1,312.31
Chapter 12 - Page 7
Answer: d
Diff: E
$2.9889
$3.1496
$3.6875
$4.0909
$4.5000
million
million
million
million
million
Medium:
Replacement chain
17
Answer: c
Diff: M
System
System
System
System
System
Chapter 12 - Page 8
L;
L;
S;
L;
S;
$2.21
$3.01
$4.10
$4.41
$6.13
million
million
million
million
million
Replacement chain
18
Answer: c
Diff: M
$ 17,298.30
$ 22,634.77
$ 31,211.52
$ 38,523.43
$103,065.82
Replacement chain
19
Answer: e
Diff: M
$23,950
$41,656
$56,238
$62,456
$71,687
Chapter 12 - Page 9
Replacement chain
20
$347,802.00
$451,775.21
$633,481.19
$792,286.54
$811,357.66
Replacement chain
.
Diff: M
21
Answer: d
Answer: c
Diff: M
$10,225.18
$11,736.26
$12,043.10
$13,424.66
$14,081.19
Chapter 12 - Page 10
Replacement chain
22
Answer: e
Diff: M
Project X
Cash Flow
-$500,000
250,000
250,000
250,000
Project Y
Cash Flow
-$500,000
350,000
350,000
Assume that both projects have a 10 percent cost of capital, and each of
the projects can be indefinitely repeated with the same net cash flows.
What is the 6-year extended NPV of the project that creates the most
value?
a.
b.
c.
d.
e.
$184,462.62
$204,844.61
$213,157.77
$248,803.75
$269,611.38
Replacement chain
23
Answer: a
Diff: M
Project A
Cash Flow
-$300
150
150
150
The
Project B
Cash Flow
-$300
200
200
Assume that each project has a 10 percent cost of capital, and assume that
the company is not capital constrained. Which of the following statements
is most correct?
a. If the two projects are independent (stand-alone) projects, then the
company would select both projects.
b. If the two projects are mutually exclusive and cannot be repeated, then
the company would select Project B.
c. If the two projects are mutually exclusive, and each can be repeated
indefinitely with the same expected cash flows, then the company would
select Project B.
d. Statements a and c are correct.
e. All of the statements above are correct.
Chapter 12 - Page 11
Answer: b
Diff: M
$135,472
$229,516
$386,512
$494,337
$616,028
Chapter 12 - Page 12
Answer: a
Diff: M
$ 1.1607
$ 2.5000
$ 5.8938
$10.0000
$11.1607
million
million
million
million
million
Chapter 12 - Page 13
Abandonment option
26
Answer: e
Diff: M
Holmes Corporation recently purchased a new delivery truck. The new truck
costs $25,000 and is expected to generate net after-tax operating cash
flows, including depreciation, of $7,000 at the end of each year. The
truck has a 5-year expected life. The expected abandonment values (salvage
values after tax adjustments) at different points in time are given below.
(Note that these abandonment value estimates assume that the truck is sold
after receiving the projects cash flow for the year.) The firms cost of
capital is 10 percent.
Year
1
2
3
4
5
Abandonment value
$20,000
15,000
10,000
5,000
0
At what point in time would the company choose to sell (abandon) the truck
in order to maximize its NPV?
a.
b.
c.
d.
e.
Tough:
Optimal project selection
27
Jackson Corporation is
investment opportunities:
Project
A
B
C
D
Answer: a
evaluating
Cost
$300,000
150,000
200,000
400,000
the
following
four
Diff: T
independent,
Rate of Return
14%
10
13
11
Project A
Projects A and C
Projects A, C, and D
All of the investment projects will be taken.
None of the investment projects will be taken.
Chapter 12 - Page 14
Answer: b
Diff: T
Cost
$200,000
600,000
400,000
400,000
400,000
IRR
20%
15
12
11
10
$ 200,000
$ 800,000
$1,200,000
$1,600,000
$2,000,000
Answer: b
Diff: T
Cost
$100,000
200,000
100,000
150,000
75,000
IRR
10.5%
13.0
12.0
14.0
9.0
$625,000
$450,000
$350,000
$550,000
$150,000
Chapter 12 - Page 15
Answer: b
Diff: T
Cost
$200,000
100,000
100,000
200,000
200,000
IRR
11.00%
10.00
9.95
9.85
9.25
$800,000
$600,000
$400,000
$300,000
$200,000
Real options
31
Answer: e
Diff: T
The company estimates that the project will last for four years.
The company will need to purchase new machinery that has an up-front
cost of $300 million (incurred at t = 0). At t = 4, the machinery
has an estimated salvage value of $50 million.
The machinery will be depreciated on a 4-year straight-line basis.
Production on the new ketchup product will take place in a recently
vacated facility that the company owns. The facility is empty and
Bucholz does not intend to lease the facility.
The project will require a $60 million increase in inventory at t =
0. The company expects that its accounts payable will rise by $10
million at t = 0.
After t = 0, there will be no changes in net
operating working capital, until t = 4 when the project is completed,
and the net operating working capital is completely recovered.
The company estimates that sales of the new ketchup will be $200
million each of the next four years.
The operating costs, excluding depreciation, are expected to be $100
million each year.
The companys tax rate is 40 percent.
The projects WACC is 10 percent.
Chapter 12 - Page 16
If Bucholz goes ahead with the project, they will have the option to pursue
a second stage project at t = 4. This second-stage project will involve a
full line of multi-colored condiments. This second stage project cannot be
undertaken, unless the first-stage project (the new ketchup product) is
undertaken today.
The company estimates today, that if they want to go
ahead with the second stage project that this will require a significant
expenditure at t = 4. However, the company does not have to decide whether
to pursue the second stage project or to spend any funds on the second
stage project until t = 4. Currently, the companys analysts estimate that
there is a 25 percent chance that demand will be high and the second stage
will have an estimated NPV (at t = 4) of $40 million, and there is a 75
percent chance that demand will be weak and the second stage will have an
estimated NPV (at t = 4) of -$75 million.
Furthermore, the analysts
believe that, by the fourth year (at t = 4), consumer preferences and
demands for the second stage project will be known with certainty. Assume
that all cash flows are discounted at the cost of capital (10 percent).
How much of an impact will this second stage option have on the companys
decision to pursue the first stage project today?
a. Since the second stage project has an expected NPV that is negative,
the existence of the second stage project makes it less likely that the
company will go ahead with the first stage project today.
b. Since the second stage project has an expected NPV that is negative,
the company will never pursue the second stage project, therefore it
will have no impact on the companys decision to undertake the first
stage project today.
c. Even though there is a second stage project, the company will reject
the first stage project as long as the NPV of the first stage project
is less than zero.
d. The existence of the second stage project means that the company will
proceed with the first stage project as the long as the NPV of the
first stage project (calculated at t = 0) is greater than negative $10
million (i.e., NPV of first stage > -$10 million.)
e. The existence of the second stage project means that the company will
proceed with the first stage project as the long as the NPV of the
first stage project (calculated at t = 0) is greater than negative
$6.83 million (i.e., NPV of first stage > -$6.83 million.)
Chapter 12 - Page 17
Multiple Part:
(The following information applies to the next two problems.)
Diplomat.com is considering a project that has an up-front cost of $3 million
and produces an expected cash flow of $500,000 at the end of each of the next
five years. The projects cost of capital is 10 percent.
Projects NPV
32
Answer: d
Diff: E
Growth options
33
Answer: a
Diff: M
If Diplomat goes ahead with this project today, the project will create
additional opportunities five years from now (t = 5).
The company can
decide at t = 5 whether or not it wants to pursue these additional
opportunities. Based on the best information that is available today, the
company estimates that there is a 35 percent chance that its technology
will be successful, in which case the future investment opportunities will
have a net present value of $6 million at t = 5. There is a 65 percent
chance that its technology will not succeed, in which case the future
investment opportunities will have a net present value of -$6 million at
t = 5. Diplomat.com does not have to decide today whether it wants to
pursue these additional opportunities. Instead, it can wait until after
it finds out if its technology is successful.
However, Diplomat.com
cannot pursue these additional opportunities in the future unless it makes
the initial investment today. What is the estimated net present value of
the project, after taking into account the future opportunities?
a. $ 199,328
b. $ 561,947
c. $ 898,205
d. -$1,104,607
e. -$2,222,265
(The following information applies to the next two problems.)
Chapter 12 - Page 18
Projects NPV
34
Answer: a
Diff: E
Answer: e
Diff: M
Now assume that one year from now OI will know if its products will have
become the industry standard. Also assume that after receiving the cash
flows at t = 1, the company has the option to abandon the project. If it
abandons the project it will receive an additional $100,000 at t = 1, but
will no longer receive any cash flows after t = 1. Assume that the
abandonment option does not affect the cost of capital. What is the
estimated value of the abandonment option?
a.
b.
c.
d.
e.
$
0
$ 2,075
$ 4,067
$ 8,945
$10,745
(The following information applies to the next two problems.)
Fair Oil owns a tract of land that may be rich with oil.
Fair must decide
whether or not to drill on this land.
Fair estimates that the project would
cost $25 million today (t = 0), and generate positive net cash flows of $10
million a year at the end of each of the next four years (t = 1, 2, 3, and 4).
While the company is fairly confident about its cash flow forecast, it
recognizes that if it waits 1 year, it would have more information about the
local geology and the price of oil. Fair estimates that if it waits one year,
the project will cost $26 million (at t = 1). If Fair Oil waits a year, there
is an 80% chance that market conditions will be favorable, in which case the
project will generate net cash flows of $12 million a year for four years (t =
2, 3, 4, and 5). There is a 20% chance that market conditions will be poor, in
which case the project will generate net cash flows of $2 million a year for
four years (t = 2, 3, 4, and 5). After finding out the market conditions at t =
1, Fair will then decide whether to invest in the project (i.e., it is not
obligated to undertake the project). Assume that all cash flows are discounted
at 10 percent.
New project NPV
36
Answer: e
Diff: E
If the company chooses to drill today, what is the projects net present
value (NPV)?
a. $4.62 million
b. $5.15 million
c. $5.80 million
Chapter 12 - Page 19
d. $6.22 million
e. $6.70 million
Investment timing option
37
Answer: c
Diff: M
Fair must decide if it makes sense for the company to wait a year to
drill. If it waits a year, what would be the expected net present value
(NPV) at t = 0?
a.
b.
c.
d.
e.
$7.629
$8.262
$8.755
$9.264
$9.391
million
million
million
million
million
Chapter 12 - Page 20
CHAPTER 12
ANSWERS AND SOLUTIONS
Chapter 12 - Page 21
1.
Abandonment option
Answer: b
Diff: E
The option to abandon will increase expected cash flow and decrease risk. If a
firm has the option to abandon a project, it will choose to do so only when
things look bad (negative NPV). Thus, abandoning a project eliminates the
low/negative cash flows. Therefore, statement b is correct.
2.
Answer: e
Diff: E
By having the ability to wait and see you reduce the risk of the project.
Therefore, statement a is false. The greater the uncertainty, the more value
there is in waiting for additional information before going on with a project.
Therefore, statement b is false. Statement c is not necessarily true. By
waiting to do a project you may lose strategic advantages associated with being
the first competitor to enter a new line of business, which may alter the cash
flows. Since statements a, b, and c are false, the correct choice is statement
e.
3.
Flexibility option
Answer: c
Diff: E
Real options
Answer: c
Diff: E
Real options
Answer: b
6.
Diff: E
the abandonment
is correct; the
Statement c is
harmful (lowers
Diff: E
Real options
Answer: a
Diff: E
8.
Real options
Answer: d
Diff: E
9.
Answer: d
Diff: E
Real options
Answer: b
Diff: M
11.
Real options
Answer: d
Diff: M
12.
Answer: a
Diff: M
By failing to consider both abandonment and growth options, the firms capital
budget would be too small.
In both cases, the firm might reject what might
otherwise be profitable projects if these options had been considered.
Therefore, the correct choice is statement a.
13.
Answer: c
Diff: E
Find the WACCs using both Johns and Beckys methods. (WACC = k s because there
is no debt).
Johns WACC for Division B based on overall companys beta:
k = kRF + RPM(b)
k = 5% + 5%(1.2)
k = 5% + 6%
k = 11%.
Therefore, John would only choose Project 1, because it is the only project
whose IRR exceeds its cost of capital. Consequently, the firms capital budget
(based on Johns WACC) is only $400 million.
Beckys WACC for Division B:
k = kRF + RPM(b)
k = 5% + 5%(0.9)
k = 5% + 4.5%
k = 9.5%.
Becky would choose projects 1, 2, 3, and 4 because all of these projects have an
IRR that exceeds the Divisions 9.5 percent cost of capital. Based on Beckys WACC,
the firms capital budget would be $1,270 million ($400 + $300 + $250 + $320).
Therefore, the firms capital budget based on Beckys WACC is $870 million ($1,270
- $400) larger than the one based on Johns WACC.
14.
Replacement chain
Step 1:
Diff: E
Step 2:
Answer: b
Determine each projects NPV by entering the cash flows into the cash
flow register and using 10 percent for the cost of capital.
NPVA = $30,283.45 $30,283.
NPVB = $29,964.48 $29,964.
Therefore, Jayhawk should select Project A since it adds more value.
15.
Replacement chain
S:
0 k = 10% 1
|
|
-8,000
5,000
IRRS = 16.26%.
NPVS = $1,237.76.
L:
Answer: d
2
|
5,000
-8,000
-3,000
3
|
5,000
4
|
5,000
3
|
4,000
4
|
4,000
Diff: E
(extended NPV)
0 k = 10% 1
|
|
-11,500
4,000
2
|
4,000
IRRL = 14.66%.
NPVL = $1,179.46.
16.
Answer: d
Diff: E
Expected NPV one year from now = 0.25($10 million) + 0.50($4 million) + 0.25($0) =
$4.5 million. Expected NPV in todays dollars = $4.5 million/1.10 = $4.0909
million.
17.
Replacement chain
Step 1:
Step 2:
18.
Answer: c
Diff: M
0
1
2
3
4
5
6
7
8
9 10 Years
|12% |
|
|
|
|
|
|
|
|
|
-3 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5
-3.0
-3.0
-3.0
-3.0
-0.5
-0.5
-0.5
-0.5
System L:
0
1
|12% |
-5
2
2
|
2
3
|
2
4
|
2
5
|
2
-4
-2
6
7
8
9 10 Years
|
|
|
|
|
1.5 1.5 1.5 1.5 1.5
System A
-100,000
60,000
60,000 - 100,000 = -40,000
60,000
60,000 - 100,000 = -40,000
60,000
60,000
System B
-100,000
48,000
48,000
48,000 - 110,000 = -62,000
52,800
52,800
52,800
Use the CF key to enter the cash flows for each period and enter I/YR = 11.
This should give the following NPVs:
NPVA = $6,796.93. NPVB = $31,211.52.
19
.
Computer system B creates the most value for the firm, so the correct answer is
c.
Replacement chain
Answer: e
Project A
-100,000
40,000
40,000
40,000
40,000
Project B
-50,000
30,000
30,000
30,000 - 55,000 = -25,000
32,000
Diff: M
5
40,000
6
40,000
NPV $71,687.18 $71,687
20.
32,000
32,000
$41,655.58 $41,656
Replacement chain
Answer: d
6
|
375
Diff: M
10
|
375
21.
9
|
400
10
|
400
100
500
CF0 = -1500000; CF1-9 = 400000; CF10 = 500000; I = 12; and then solve for NPVB =
$792,286.54.
Replacement chain
Answer: c Diff: M
Bus S:
0 k =
|
-50,000
1
|
25,000
15%
2
|
25,000
3
|
25,000
-50,000
-25,000
4
|
25,000
5
|
25,000
6
|
25,000
4
|
23,000
5
|
23,000
6
|
23,000
IRRS = 23.38%.
NPVS = $11,736.26 (extended NPV).
Bus L:
0 k = 15% 1
|
|
-75,000
23,000
2
|
23,000
3
|
23,000
IRRL = 20.80%.
NPVL = $12,043.10.
The better project will change GBLs value by $12,043.10.
22.
Replacement chain
Answer: e
Diff: M
The cash flows (using the replacement chain) for both projects are:
Project X:
Project Y:
It is expected to
23.
Replacement chain
Answer: a
Diff: M
Project A
-$300
150
150
150 300 = -150
150
150
150
Project B
-$300
200
200 300 = -100
200
200 300 = -100
200
200
Answer: b
Diff: M
Calculate the expected NPV of the project today. The expected cash
flow is (0.75)($500,000) + (0.25)($50,000) = $387,500. To find the NPV
of the project, enter the following data inputs in the financial
calculator:
CF0 = -1500000; CF1-7 = 387500; I = 10; and then solve for NPV =
$386,512.
Step 2:
Calculate the NPV of the project if it waits. If the firm waits, it will
know with certainty whether the product has become the industry
standard. It will do the project only if the cash flows are $500,000. To
find the NPV at t = 0 of the project if it waits, enter the following
data inputs in the financial calculator:
CF0 = 0; CF1 = -1500000; CF2-7 = 500000; I = 10; and then solve for NPV
= $616,028.
Step 3:
25.
Diff: M
Abandonment option
Answer: e
Diff: M
In order to solve this problem, you calculate the trucks NPV at each point in
time and then choose the truck life that maximizes its NPV.
Abandon after Year 1:
= -$455.
CF0 = -25000; CF1 = 27000; I = 10; and then solve for NPV
Abandon after Year 2: CF0 = -25000; CF1 = 7000; CF2 = 22000; I = 10; and then
solve for NPV = -$455.
Abandon after Year 3:
solve for NPV = -$79.
No abandonment:
$1,536.
CF0 = -25000; CF1-5 = 7000; I = 10; and then solve for NPV =
Thus, the firm (in order to maximize its NPV) would never choose to sell the
truck.
27.
Answer: a
Diff: T
Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the
company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then
it will retain earnings of $50,000.
The retained earnings breakpoint is
$50,000/0.4 = $125,000. Since it will require financing in excess of $125,000
to undertake any of the alternatives, we can conclude the firm must issue new
equity. Therefore, the pertinent component cost of equity is the cost of new
equity.
Calculate the expected dividend per share (note this is D 1) as
28.
Answer: b
Diff: T
Answer: b
Diff: T
Calculate the retained earnings break point (BP RE) as $300,000/0.6 = $500,000.
Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% = 13.07%. Calculate k e as D1/(P0 F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%. Find WACC below BPRE as: WACC =
0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed
at 10.18%. Find WACC above BPRE as: WACC = 0.6(14.48%) + 0.4(9%)(1 - 0.35) =
11.03%. Thus, financing in excess of $500,000 costs 11.03%. Projects 2, 3, and
4 all have IRRs exceeding either WACC and should be accepted. These projects
require $450,000 in financing. Project 1 is the next most profitable project.
Given its cost of $100,000, half or $50,000 can be financed at 10.18% and the
other half must be financed at 11.03%. The relevant cost of capital for Project
1 is then 0.5(10.18%) + 0.5(11.03%) = 10.61%. Since Project 1s IRR is less
than the cost of capital, it should not be accepted. The firms optimal capital
budget is $450,000.
30.
31.
Answer: b
Diff: T
Step 1:
Step 2:
Calculate the WACCs: (There will be two: one with retained earnings
and one with new equity.)
WACC1 = [0.4 8% (1 - 0.4)] + [0.6 12%] = 9.12%.
WACC2 = [0.4 8% (1 - 0.4)] + [0.6 13%] = 9.72%.
Step 3:
Real options
Answer: e
Diff: T
The correct answer is statement e. To see this, you must evaluate the followon project after the initial project has been evaluated.
The project cash flows are shown below (in millions of dollars):
Up-front costs
Increase in NOWC
Sales
Operating costs
Depreciation
EBIT
Taxes
EBIT(1 - T)
Depreciation
Operating CF
AT(SV)
NOWC recovery
Net CF
Year
0
-300
-50
-350
200
-100
-75
25
-10
15
75
90
200
-100
-75
25
-10
15
75
90
200
-100
-75
25
-10
15
75
90
90
90
90
200
-100
-75
25
-10
15
75
90
30
50
170
Projects NPV
Answer: d
Diff: E
Find the projects NPV using a financial calculator and entering the following
data inputs:
CF0 = -3000000; CF1-5 = 500000; I = 10; and then solve for NPV = -$1,104,607.
33.
Growth options
Answer: a
Diff: M
0 k = 10% 1
2
3
4
5
|
|
|
|
|
|
-3,000,000 500,000 500,000 500,000 500,000 500,000
NPV = -1,104,607
+1,303,935
NPV = +6,000,000 (35%)
$ 199,328
NPV = -6,000,000 (65%)
Step 1:
CF0 = -3000000; CF1-5 = 500000; I = 10; and then solve for NPV =
-$1,104,607.
Step 2:
Step 3:
34.
35.
considering
Projects NPV
Answer: a
its
future
Diff: E
Step 1:
Step 2:
Find the projects NPV by entering the following data inputs in the
financial calculator:
CF0 = -250000; CF1-5 = 67500; I = 12; and then solve for NPV =
-$6,678.
Answer: e
Diff: M
No abandonment:
Yr. 0
0.5
Prob
1
2
3
4
5
Prob
NPV
NPV
|
|
|
|
|
110,000 110,000 110,000 110,000 110,000 0.5 $146,525 $73,263
-250,000
0.5
25,000
25,000
25,000
25,000
25,000 0.5
159,881 79,941
E(NPV) = $-6,678
Abandonment:
Yr. 0
0.5
Prob
1
2
3
4
5
Prob
NPV
NPV
|
|
|
|
|
110,000 110,000 110,000 110,000 110,000 0.5 $146,525 $73,263
-250,000
0.5
125,000
36.
Answer: e
Diff: E
We can solve for NPV by entering the following data into the cash flow
register.
CF0 = -25000000; CF1 = 10000000; CF2 = 10000000; CF3 = 10000000; CF4 = 10000000;
I/YR = 10; and then solve for NPV = $6,698,654 $6,700,000.
37.
Answer: c
Diff: M
Fair will only invest if market conditions are favorable, hence the 20% chance
of receiving $2 million annual cash flows is really 0% because the NPV < 0.
Therefore, the NPV of the project as of t = 1, can be found using the
calculator and entering the following data:
CF0 = -26000000; CF1 = 12000000; CF2 = 12000000; CF3 = 12000000; CF4 = 12000000;
I/YR = 10; and then solve for NPV = $12,038,385. But, there is only an 80%
chance of this occurring so expected NPV = 0.8 $12,038,385 = $9,630,708.
Now, we must find the NPV of the project as of Year 0, which is found by
taking the present value of $9,630,708 received in Year 1.
NPV of project = $9,630,708/1.1
NPV of project = $8,755,189.