Problem 1:
Here is a summary of the cash flows for a project which has recently been submitted to a review committee.
Time Period Annual Cash Flow (after taxes)
0 -$1,600,000
1 600,000
2 600,000
3 400,000
4 400,000
Additional information which applies to this investment is:
- The company uses NPV to evaluate all investments.
- The required return on this investment is 15% per year.
- There are actually two possible scenarios for the annual cash flows in years 1-4. Each scenario has a 50% probability associated with it.
- Under the pessimistic scenario, annual cash flows would be $200,000 for years 1 and 2, and $0 for years 3 and 4.
- Under the optimistic scenario, annual cash flows would be $1,000,000 for years 1 and 2, and $800,000 for years 3 and
Problem 2. The group presenting this project calculated the weighted average cash flows for each year in developing the numbers in the table above.
- If the project is unsuccessful, the company will have the opportunity to liquidate their investment for ½ its original amount at the end of year two. There is no liquidation value at the end of year 4.
Based on the values in the table above, members of the committee have calculated a NPV of -$130,000. They are talking about rejecting the project. You, however, wonder if this is correct. What alterations, if any, do you recommend in the analysis thus far? Explain.