Case Study:
Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years.There is a 30 percent probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years. There is a 40 percent probability of medium conditions, in which case the annual cash flows will be $4 million, and there is a 30 percent probability of bad conditions and a cash flow of -$1 million per year. BSI uses a 12 percent cost of capital to evaluate projects like this.
a. Find the project's expected cash flows and NPV.
b. Now suppose the BSI can abandon the project at the end of the first year by selling it for $6 million.
BSI will still receive the Year 1 cash flows, but will receive no cash flows in subsequent years. Assume the salvage value is risky and should be discounted at the WACC.
c. Now assume that the project cannot be shut down. However, expertise gained by taking it on will lead to an opportunity at the end of Year 3 to undertake a venture that would have the same cost as the original project, and the new project's cash flows would follow whichever branch resulted for the original project.
In other words, there would be a second $10 million cost at the end of Year 3, and then cash flows of either $9 million, $4 million, or -$1million for the following 3 years. Use decision tree analysis to estimate the value of the project, including the opportunity to implement the new project in Year 3. Assume the $10 million cost at Year 3 is known with certainty and should be discounted at the risk-free rate of 6 percent.
Hint: do one decision tree for the operating cash flows and one for the cost of the project, then sum their NPVs.