Today’s date is January 1, 2020. You are tasked with evaluating the following software company venture. The venture will require an initial capital expenditure of 40 today in machinery; you will not be able to declare any depreciation expenses associated with this expenditure, and it has no salvage value (you will not be able to claim a capital loss or tax credit either). At the end of this year, you expect to earn 100 in revenues and incur labor costs of 40, if you invest in the machinery today. On January 1, 2022, you will be faced with another capital expenditure for computing equipment, but the cost of this equipment is uncertain as of today. The computing equipment may cost 110 (expensive) with 50% probability, or may cost 40 (cheap) with 50% probability. The computing equipment can be depreciated using the straight-line method over two years; the equipment will have zero salvage value irrespective of whether it was cheap or expensive. If you indeed invest in computing equipment, then you will again expect to earn revenues of 100 and incur labor costs of 40 for two years in a row, on December 31, 2022 and December 31, 2023. The project will end on December 31, 2023. All cash flows other than capital expenditures are realized at the end of the year. The tax rate is 20%, and the discount rate for this project is 10%.

A) What is the NPV of the project as of today, assuming you must invest in both the machinery and the computing equipment?

B) Suppose you have the option of doing research for one year starting today (January 1, 2020) to determine with 100% certainty whether computing equipment in the future will be expensive or cheap. Conducting this research will delay the entire project by one year. After doing research for one year and learning the future price of computing equipment, you will have the options to invest at two different points in time during the project's life: you can choose whether to incur the initial CAPEX on machinery on January 1, 2021, and then choose whether to incur the second CAPEX on the computing equipment on January 1, 2023. For example, you can invest in the initial machinery on January 1, 2021 and realize cash flows on December 31, 2021, and then refrain from spending money on the computing equipment on January 1, 2023 (and therefore no longer realize any subsequent cash flows from the project). You can also choose to purchase computing equipment but refrain from investing in machinery, and then realize cash flows in the final two years of the project after you invest in computing equipment. What is the NPV of the project now? Does it benefit you to wait and conduct research into the price of computing equipment?

C) Now we will compare the investment strategies in parts a) and b), but now suppose the probability that the computing equipment will be expensive is unknown: call it x (and thus the probability that the computing equipment will be cheap is: 1-x). What must be the value of x such that you would be indifferent between investing in the strategy in part a (i.e. investing in the project now without conducting research) and investing in the strategy in part b (i.e. doing research for a year into the price of computing equipment and then making investment decisions accordingly)? If you are unable to solve for x, please describe in words what additional information you would need to solve the problem and how you would go about solving it.

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A The NPV of the project as of today assuming you must invest in both the machinery and t... View the full answer