finance- formulas for the NPV

QUESTION

PROBLEM 13-5

Problem 5
First
Project

Year 1
Year 2
Year 3
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PV (good state)
150
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15
15
15

prob = 50%

Investment
-100

prob = 50%

PV (bad state)
0

0
0
0
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NPV

Follow-On
Opportunity (Year 1)

Year 2
Year 3
Year 4

PV
1500

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150
150
150
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prob = 50%

Investment
-1000

prob = 50%

PV
900

90

90
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NPV

Solution
Legend

= Value given
in problem

=
Formula/Calculation/Analysis required

=
Qualitative analysis or Short answer required

= Goal Seek
or Solver cell

= Crystal
Ball Input

= Crystal
Ball Output

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 this project will be a complete failure and 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.

ANSWER:

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