Question

ALiBaba industries is considering to start new project! The Project either start today or exactly in...

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?

Homework Answers

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.

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