Games Unlimited Inc.is considering a new game that would require an investment of $20.0 million.If the new game is well received,then the project would produce cash flows of $9.5 million a year for 3 years.However,if the market does not like the new game,then the cash flows would be only $6.0 million per year.There is a 50% probability of both good and bad market conditions.The firm could delay the project for a year while it conducts a test to determine if demand would be strong or weak.The project's cost and expected annual cash flows would be the same whether the project is delayed or not.If the WACC is 9.0%,what is the value (in thousands)of the investment timing option?
A)$1,857
B)$2,042
C)$2,246
D)$2,471
E)$2,718

Question

Games Unlimited Inc.is considering a new game that would require an investment of $20.0 million.If the new game is well received,then the project would produce cash flows of $9.5 million a year for 3 years.However,if the market does not like the new game,then the cash flows would be only $6.0 million per year.There is a 50% probability of both good and bad market conditions.The firm could delay the project for a year while it conducts a test to determine if demand would be strong or weak.The project's cost and expected annual cash flows would be the same whether the project is delayed or not.If the WACC is 9.0%,what is the value (in thousands)of the investment timing option? ​
A)$1,857
B)$2,042
C)$2,246
D)$2,471
E)$2,718

Quizplus · Accepted Answer

To find the value of the investment timing option, we need to calculate the present value of the project with and without delay. We can use the NPV formula for both scenarios:

NPV with delay = -20 + 0.5(0.5*9.5 + 0.5*6)/(1+9%) + 0.5(0.5*9.5 + 0.5*6)/(1+9%)^2 + 0.5(0.5*9.5 + 0.5*6)/(1+9%)^3 = $15,466

NPV without delay = -20 + 0.5*9.5/(1+9%) + 0.5*6/(1+9%)^2 + 0.5*6/(1+9%)^3 = $16,323

The value of the investment timing option is the difference between the two NPV values:

Investment timing option = $16,323 - $15,466 = $857,000 or $857

Therefore, the best choice is to delay the project for a year to conduct a test, as the investment timing option is positive.