Now assume that there is more uncertainty about the future after-tax cash flows. More specifically, assume...

  

Transcribed Image Text:

Now assume that there is more uncertainty about the future after-tax cash flows. More specifically, assume that the annual after-tax cash flows are $53,500 if the market is strong and $13,500 if the market is weak. Assume that the up-front after-tax cost is still $100,000 and that the WACC is still 10%. Will this Increased uncertainty make the firm more or less willing to invest in the project today? Explain. WACC= 10% End of time period Scenario NPV at t=1 0 1 2 3 4 5 50% ($100,000) $53,500 $53,500 $53,500 $53,500 $69,587.80 B $0 9 50% ($100,000) $13,500 $13,500 $13,500 $13,500 ($57,206.82) 0 1 Again, the firm will not choose to pursue Project X in the weak market. The expected NPV of the 2 project at t=1 then equals $34,793.90, and $31,630.82 at t=0. 53 57 58 59 54 The more variable the cash flows (the more uncertainty) the less willing the firm will be to invest in the project today. 55 56 Factors the firm should consider when deciding when to invest: (1) Delaying the project means that cash flows come later rather than sooner. 60 61 (2) It might make sense to proceed today if there are important advantages to being the first competitor to enter a market. (3) Waiting may allow you to take advantage of changing conditions. 62 NPV of Project X @t=1 = 63 NPV of Project X + 64 65 Value of option = $34,793.90 Now assume that there is more uncertainty about the future after-tax cash flows. More specifically, assume that the annual after-tax cash flows are $53,500 if the market is strong and $13,500 if the market is weak. Assume that the up-front after-tax cost is still $100,000 and that the WACC is still 10%. Will this Increased uncertainty make the firm more or less willing to invest in the project today? Explain. WACC= 10% End of time period Scenario NPV at t=1 0 1 2 3 4 5 50% ($100,000) $53,500 $53,500 $53,500 $53,500 $69,587.80 B $0 9 50% ($100,000) $13,500 $13,500 $13,500 $13,500 ($57,206.82) 0 1 Again, the firm will not choose to pursue Project X in the weak market. The expected NPV of the 2 project at t=1 then equals $34,793.90, and $31,630.82 at t=0. 53 57 58 59 54 The more variable the cash flows (the more uncertainty) the less willing the firm will be to invest in the project today. 55 56 Factors the firm should consider when deciding when to invest: (1) Delaying the project means that cash flows come later rather than sooner. 60 61 (2) It might make sense to proceed today if there are important advantages to being the first competitor to enter a market. (3) Waiting may allow you to take advantage of changing conditions. 62 NPV of Project X @t=1 = 63 NPV of Project X + 64 65 Value of option = $34,793.90