Question

A company is considering investing in a project. The present value (PV) of future discounted expected cash flows is either 7000 if the market goes up or 3000 if the market goes down next year. The probability the market will go up is 35%. The initial capital investment required at time 0 is 4000. Suppose the company has some flexibility in managing this project. If, however, the market should go up, the company could expand operations. With expansion the PV will be 55% larger than the original PV forecast. To expand the company will have to make an additional capital expenditure of 1000. Calculate the expected NPV of this project with flexibility option

Answer 1

Cash flow in case of market goes up = 7000 ( a)

cash flow in case of market goes down = 3000 ( b)

Probability of market going up = 35% ( c)

Probability of market going down = ( 1- 0.35 ) = 65%

Expected cash flow from the project = a* c + b*d = 7000 * .0.35 + 3000 * 0.65 = 4400

Now it is said that the if invested in expansion then cash flow = 55% of cash flow if market goes up

= 7000* 0.55 = 3850

Net present value of the project without the expansion = Expected inflows - outflow = 4400 - 4000 = 400

Net present value for expansion = 3850 - 1000 = 2850

Expected net present value from expansion = 2850 *0.35 = 997.50

expected NPV of this project with flexibility option = NPV of project without the flexibilty option + npv of flexibility option = 400 + 997.50 = 1397.50