Consider the problem of Wind Resources (described in the section The Timing Option in this chapter). WRI
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Consider the problem of Wind Resources (described in the section “The Timing Option” in this chapter). WRI is contemplating developing an attractive wind farm site it owns in Southern California. A consultant estimates that at the current natural gas price of 6 cents/kWh (cents per kilowatt hour), immediate development will yield a profit of $10 million. However, natural gas prices are quite volatile. Suppose the price in one year will be either 8 cents/kWh or 4 cents/kWh with equal probability. According to the consultant, WRI’s profit will jump to $30 million at a price of 8 cents/kWh and fall to a loss of $10 million at 4 cents/kWh. Because the company won’t receive these profits for one year, discount them to the present at a high, risk-adjusted rate of 25 percent. WRI is now considering whether to wait to develop the wind farm. a. Draw a decision tree that captures WRI’s decision. b. What should WRI do? What is the resulting NPV of this project? c. What is value of the option to wait? d. Suppose that the change in natural gas prices in one year will be more dramatic than originally envisioned in the problem. In particular, gas prices will either rise to 12 cents/kWh or fall to 2 cents/kWh with equal probability. According to the consultant, WRI’s profit will be $60 million at a price of 12 cents/kWh or fall to a loss of $30 million at 2 cents/kWh. What is the new value of the option to wait? How is the value of the option affected by the wider dispersion of natural gas prices?
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a At the 25 discount rate the present value of 30 million is 24 million 24 30 125 and the present va...View the full answer
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NPV stands for \"Net Present Value,\" which is a financial concept used to determine the value of an investment or project. It measures the difference between the present value of cash inflows and the present value of cash outflows over a given period of time, using a specific discount rate.
To calculate the NPV of an investment, you need to first estimate the cash inflows and outflows associated with the investment, and then discount them back to their present values using a discount rate. The discount rate represents the cost of capital or the expected rate of return required by investors.
The formula for calculating NPV is:
NPV = sum of (cash inflows / (1 + discount rate)^t) - sum of (cash outflows / (1 + discount rate)^t)
Where:
Cash inflows: the expected cash received from the investment
Cash outflows: the expected cash paid out for the investment
Discount rate: the required rate of return or the cost of capital
t: the time period in which the cash flow occurs
If the NPV is positive, it means that the investment is expected to generate a return higher than the required rate of return or the cost of capital, and it may be considered a good investment. If the NPV is negative, it means that the investment is not expected to generate a return higher than the required rate of return or the cost of capital, and it may be considered a bad investment.