An investment of I = $2, 000 dollars now results in the cash flow Fn = $50,
n = 0, 1, . . . ....∞
Assume that the inflation-free interest rate is currently i = 2.5%. The inflation-free interest rate will change at the end of the first year. There is a 0.5 probability that it will increase to 3%, and a 0.5 probability that it will decrease to 2%. It will then remain at this new level.
1. What is the expected net present value of the project if you invest at time zero? Would you invest in this project if you had to make the decision at time zero?
2. Suppose that you decide to wait a year until the interest rate uncertainty is resolved. Would you invest if the interest rate goes up? Would you invest if the interest rate goes down?
3. Find the expected net present value, ENPVw that results from waiting and investing only if it is to your advantage. Is it better to wait?