Oregon Lumber is considering the purchase of a paper company. Purchasing the company would require an initial investment of $300 million. Oregon estimates that the paper company would provide net cash flows of $40 million at the end of each year for the next 20 years. The cost of capital for the paper company is 13%.
a. Should Oregon purchase the paper company?
b. While Oregon’s best guess is that cash flows will be $40 million a year, it recognizes that there is a 50% chance the cash flows will be $50 million a year, and a 50% chance that the cash flows will be $30 million a year. One year from now it will find out whether the cash flows will be $30 million or $50 million. In addition, 1 year from now, Oregon also recognizes that if it wanted, it could sell the company in 2 years for $280 million. Given this additional information, does it make sense to purchase the paper company? Again assume all cash flows are discounted at 13%.