Question

Footstar Company is considering a project that has been assigned a discount rate of 12 percent. If the company starts the project today, it will incur an initial cost of $565,000 and will receive cash inflows of $210,000 a year for five years. If the company waits one year to start the project, the initial cost will rise to $630,000 and the cash flows will increase to $240,000 a year for five years. What is the value of the option to wait?

Answer 1

The value is computed as shown below:

Current net present value is computed as follows:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 565,000 + $ 210,000 / 1.12¹ + $ 210,000 / 1.12² + $ 210,000 / 1.12³ + $ 210,000 / 1.12⁴ + $ 210,000 / 1.12⁵

= $ 192,003.0025

The NPV to wait is computed as follows:

= - $ 630,000 / 1.12 + $ 240,000 / 1.12² +  $ 240,000 / 1.12³ +  $ 240,000 / 1.12⁴ +  $ 240,000 / 1.12⁵ +  $ 240,000 / 1.12⁶

= $ 209,952.0434

So, the value is computed as follows:

= $ 209,952.0434 - $ 192,003.0025

= $ 17,949.04 Approximately

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