Question

ALiBaba industries is considering to start new project! The Project either start today or exactly in two years. The project will cost £10.8 million to start today. The cost of starting project in two years is £12 million. You expect the project to generate £1,250,000 in free cash flow per year forever. The risk free rate is 4.5%. The expected return on the market is 9%, and beta for projects of similar risk is 1.5. The variance of the project's cash flows is 13%.

1. what is the NPV of the option to wait until year 2 to start the project?

2. Should you begin the project today or wait for two years?

Answer 1

Required return from the project = 4.5%+1.5*(9%-4.5%) = 11.25%

1. The option to wait for 2 years saves the today's cost of 10.8 million pounds but one also does not get the year 1 and year 2 cashflows of 1.25 million pounds and the cost at the end is 12 million pounds

So,

NPV of option = 10.8- 1.25/1.1125-1.25/1.1125^2-12/1.1125^2 = -1.02931

So, NPV of option to wait until 2 years is -1.02931 million pounds

2

NPV of the project today = -10.8+1.25/0.1125 = 0.311 million pounds

. As the NPV of the option is negative, the NPV with delayed start will have lesser NPV than the NPV if started today. So, one should start the project today.