Question

Suppose you are the CEO of MotorABC, and you are considering investing in the following project. The life cycle of the project takes 6 years. During the first three years, the project requires fixed investments, and the project generates risky earnings throughout its life cycle.

The investments committed to the project are shown in the following table:

Year	0	1	2	3
Investments (million)		6	6	6

The expected earnings from the project are shown in the following table:

Year	0	1	2	3	4	5	6
Earnings (million)		5	5	5	5	5	5

Suppose the yield curve (EAR) is flat at 1%, and the discount rate for the risky Earnings is flat at 20%. You are standing at time 0 now. State any additional assumptions you need to make.

(a) What is the NPV of the project. Would you invest in this project?

(b) Suppose now the earnings for the first three years (1,2,3) are guaranteed and no longer risky while the risk of the remaining earnings stays the same, would you invest in the project? Explain.

Answer 1

Year	cashflow (million)	discount factor @ 20%	PV of cashflow (million)
1	-6	0.833	(4.998)
2	-6	0.694	(4.164)
3	-6	0.579	(3.474)
1	5	0.833	4.165
2	5	0.694	3.47
3	5	0.579	2.895
4	5	0.482	2.41
5	5	0.402	2.01
6	5	0.335	1.675
			3.989

a) NPV of the project = 3.989 million

b) If only the earnings of first 3 years is guaranteed, the NPV of the project = 10.53 million - 12.636 million = (2.106 million) loss

So it is advisable to not invest in the project.