You are planning to invest in a project for the production of widgets. The cost of the project is $10M and the project generates a single cash flow one year after the investment. Demand for widgets can be either high or low with equal probability. If demand is high, the cash flow that the project generates is $22M. If demand is low, this cash flow is only $6M. Assume demand is uncorrelated with the market so that you can discount at the risk free rate of 10%.
a. What is the NPV of the project?
b. Suppose that you can commission a study that costs $1.5M today (year 0). This study will tell you whether demand is high or low. However, the study will take one year to complete. That is, if you commission the study, you pay the $1.5M today (year 0), then you decide whether or not to invest in year 1, and if you invest, the cash flow arrives at year 2. Should you commission this study?