Question

Industrialization Enterprise is considering a three-year project that will require an initial investment of $43,500. If market demand is strong, Industrialization Enterprise thinks that the project will generate cash flows of $28,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,750 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

If the company uses a project cost of capital of 12%, what will be the expected net present value (NPV) of this project?

-$7,172

-$6,813

-$8,606

-$6,096

Industrialization Enterprise has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.

What will be the expected NPV if Industrialization Enterprise delays starting the project?

$4,166

$24,952

$2,083

$1,771

What is the value of Industrialization Enterprise’s option to delay the start of the project?

$24,952

$2,083

$1,771

$4,166

Answer 1

Year	0.00	1.00	2.00	3.00
Initial Investment	43,500.00
Cash flows(Strong)	0.50	28,500.00	28,500.00	28,500.00
Cash flows(Weak)	0.50	1,750	1,750	1,750
Expected cash flows		15,125	15,125	15,125
Project cost of capital	12%
NPV	-7,172.30
Answer is -7172
Year	0.00	1.00	2.00
Initial Investment	43,500.00
Cash flows(Strong)		28,500.00	28,500.00
Project cost of capital	12%
NPV	4,166.48	Using NPV formula to get value at year 1 and divide it by 1.12 to get value today
Answer is 4166.48
Value of the option to delay the project is 4166