Imagine you value the following industrial project:
Initial Costs = $29 mil (to be paid at T=0)
Project Benefits = $0 in Years 1 and 2, then $6.75 mil in EVERY year from Year 3 to Year 10 (assume the cash flows will be generated at the end of year 3, year 4,…, year 10).
The discount rate of the project: The project will be valued by an all-equity company TODAY. The beta of the company is 1.85, and the project under consideration has riskiness similar to the typical risk of other firm’s projects.
What is the dollar value of the decision to accept the project now? Should you accept the project? Why or why not?
Assume that you have a business partner who wants to persuade you to adopt the project. Consequently, the partner makes a contractual promise to you that if you start the project, then EXACTLY 2 year from today the partner will be ready to buy the project (benefits) from you for the fixed price of $24 mil (if you want to sell).
Note that since project will not produce any free cash flows in Year 1 and 2, the combined value of your project benefits will NOT deteriorate during the next year (that is, your project benefits will not “lose dividends”).
However, you have to understand that the project benefits are uncertain, and they can change in the future. In fact, the annualized volatility of changes in the cumulative value of project benefits is 48% per year.
What is the dollar value of the partner’s guarantee to you?
Should you accept the project given the partner’s guarantee? Why or why not?