Question

You are considering a project that you expect will produce $200 FCFF every year in perpetuity. Depending on whether the project is successful or not, however, the demand one year from today will be either low, producing $100 FCFF in perpetuity, or high, producing $300 FCFF in perpetuity. The high and low demand outcomes are equally likely and will be revealed in one year. The revealed outcome is expected to persist forever. The project cost is $1,000. The discount rate for the first year is 30% and 15% for subsequent years. The project can be dismantled and sold at the end of the first year for $700 after taxes. Should you take the project?

Answer 1

NPV of perpetuity = (Cash-flows per year) / Discount rate

If the demand is high after the first year, the NPV(high)

NPV(high) = $538.46

If the demand is low after the first year, the NPV(low)

NPV(low) = -487.18

Since the NPV(low) is negative, the project can be dismantled and sold at the end of the first year for $700 after taxes

NPV(dismantled) = -461.538

Since the NPV(dismantled) is less negative than NPV(low), project will be dismantled at the end of year one of the project is unsuccessful

The probability of high demand = the probaility of low demand and project being dismantled = 0.5

Expected NPV = 0.5*538.46 + (0.5* -461.54)

Expected NPV = 38.46

Since the expected NPV of the project is positive, the project ca