ABC company is considering a project that has an initial cost today of $10,000. The project has a two-year life with cash inflows of $6,500 each year (i.e. t=1 and t=2). 

Should ABC company decide to wait one year to commence this project, the initial cost will increase by 5%. Then: 

If market conditions are favourable, the project cash inflows will increase to $7,500 each year for the following two years (i.e. t=2 and t=3). 

If market conditions become more subdued, cash inflows would be only $6,500 in the first year (t=2) and $5,000 in the next year (t=3). 

Assume that the project can only be commenced now or in exactly 1 year and that all positive cash flows are at year-end. The appropriate risk-free rate of return is 5% p.a. Ignore taxes. 

Required

a) Draw a fully labelled decision tree showing the alternatives available to ABC company. Indicate decision and information nodes, decisions, timings, and values. (3 marks)

b) Calculate the value of the project if ABC company commences the project today. (2 marks)

c) Should the ABC company wait one year to commence the project? Answer the question using the risk-neutral two-state binomial model to calculate the value the option to wait. (5 marks)

Answer rating: 100% (QA)

SOLUTION a Decision Tree Today t0 10000 Decision Node 6500 7500 6500 6500 5000 t1 t2 t2 t3 b To calc... View the full answer