The executives of GW Inc. are considering a project that has an upfront cost of $3 million.
Question:
The executives of GW Inc. are considering a project that has an upfront cost of $3 million.
This project is expected to produce a cash flow of $500,000 at the end of each of the next 5 years.
The cost of capital is 10% If GW goes ahead with the project today, it will obtain knowledge that will give rise to additional opportunities 5 years from today. The company can decide at t=5 whether or not it wants to pursue these additional opportunities.
Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t=5.
There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million.
GW does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today at t=0.
What is the estimated net Present value of the project, after consideration of the potential future opportunity?
Fundamentals of Financial Management
ISBN: 978-1337395250
15th edition
Authors: Eugene F. Brigham, Joel F. Houston