1. A company is considering investing in a project. The future perpetual cash flow is either $750K if the market goes up or $125K if the market goes down next year. The objective probability the market will go up is 20%. The appropriate risk-adjusted rate of return (cost of capital) is 25%. The initial capital investment required at time 0 is $1200K. а. Should the company invest in this project? b. Upon closer inspection the CFO realizes the company actually has some flexibility in managing this project. Specifically, if the market goes down, the company can abandon the project, and liquidate its original capital investment for 75% of its original value. If, however, the market should go up, the company could expand operations, which would result in twice the original PV of the cash flows. To expand the company will have to make an additional capital expenditure of $800K. The CFO wants to know if the company should now proceed with the project with the added flexibilities, and asks for you advice
1. A company is considering investing in a project. The future perpetual cash flow is either $750K if the market goes up or $125K if the market goes down next year. The objective probability the market will go up is 20%. The appropriate risk-adjusted rate of return (cost of capital) is 25%. The initial capital investment required at time 0 is $1200K.
а. Should the company invest in this project?
b. Upon closer inspection the CFO realizes the company actually has some flexibility in managing this project. Specifically, if the market goes down, the company can abandon the project, and liquidate its original capital investment for 75% of its original value. If, however, the market should go up, the company could expand operations, which would result in twice the original PV of the cash flows. To expand the company will have to make an additional capital expenditure of $800K. The CFO wants to know if the company should now proceed with the project with the added flexibilities, and asks for you advice.
Trending now
This is a popular solution!
Step by step
Solved in 3 steps with 2 images
