Question

XYZ Inc. wants to invest in a project where the initial investment requires 5 Billion. The annual discount rate is 5%

Here are the other details about the investment:

At the end of the year, the demand might be High or Low with chances of 60% or 40%, respectively.

Also at the end of the year, XYZ will also know whether its production facilities are producing enough or not. The probabilities of having enough vs not enough production are equal.

The payoffs are: High Demand – High Production: 25Billion $.

     High Demand – Low Production: 10Billion $.

     Low Demand – High Production: 5 Billion $.

     Low Demand – Low Production: 0 Billion $.

If the demand is low and production is high they can choose one of the following options:

  Option 1

• They can produce CELL PHONE in the same facilities. This will cost them 10Billion immediately
• The payoff would be 40 Billion by the end of 24 months (2 years from the initial investment of 5 Billion)

OR

Abandon Option

• They can sell all the facilities to a Chinese company. The payoff would be immediate 25Billion dollars.

Draw the decision tree.

What is the NPV of XYZ in this scenario? (Show your calculations step by step and explain why you chose/or did not choose a particular option)

Answer 1

CALCULATION OF NPV:

Production of Cello Phone will have Present Value after one year =($40billio/1.05)-$10(Investment)=$28.09524 billion

(Note discount Rate=5%=0.05)

If it is abandoned, company will get $25 billion

Hence, it should opt for manufacturing cello phone

Net payoff at the end of one year=$5 billion +$28.09524 billion=$33.09524 billion

SCENARIO		Probability	Payoff($ billion)	Payoff* Probability
High Demand-	High Production	0.3	25	7.5
High Demand-	Low Production	0.3	10	3
Low Demand-	High Production	0.2	33.09524	6.619048
Low Demand-	Low Production	0.2	0	0
			Total	17.11905

Expected payoff at the end of year=$17.11905 billion

Present value of expected payoff at 5% discount =17.11905/1.05=$16.30386 billion

Initial Investment =$5 billion

Net Present Value (NPV)=($16.30386-$5)billion=$11.30386 billion