Norris Production Company (NPC)is considering a project that has an up-front cost at t = 0 of $2,400.(All dollars in this problem are in thousands. )The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration.If the FDA rejects the competitive product,NPC's product will have high sales and cash flows,but if the competitive product is approved,that will negatively impact NPC.There is a 50% chance that the competitive product will be rejected,in which case NPC's expected cash flows will be $700 at the end of each of the next seven years (t = 1 to 7).There is a 50% chance that the competitor's product will be approved,in which case the expected cash flows will be only $50 at the end of each of the next seven years (t = 1 to 7).NPC will know for sure one year from today whether the competitor's product has been approved.
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NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision.If it waits a year,the project's up-front cost at t = 1 will remain at $2,400,the subsequent cash flows will remain at $700 per year if the competitor's product is rejected and $50 per year if the alternative product is approved.However,if NPC decides to wait,the subsequent cash flows will be received only for six years (t = 2 ...7).In addition,once NPC knows the outcome of the FDA's decision,it will not take on the project if its NPV is negative.
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This is a risky project,so a WACC of 16.0% is to be used.If NPC chooses to wait a year before proceeding,what is the value (in thousand)of the timing option today? Do not round intermediate calculations.
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A) $88.88
B) $92.75
C) $73.43
D) $77.29
E) $57.97

Question

Quizplus · Accepted Answer

Invest immediately:
? 11ea856c_8b8a_73c4_9aec_ef8e925dd1c5_TB1222_00 ?
Delay,then invest in period 1 if the outlook is good:
? 11ea856c_8b8a_73c5_9aec_4969c223c5cc_TB1222_00 ?
*The NPV under the delay option occurs one year later,so it must be discounted back to t = 0 at the cost of capital to make the NPVs comparable.The value of the timing option is the difference between the expected value of the project with and without the timing option.However,if the NPV of the project without the option is negative,then the value of the option is simply the NPV of the project with the option (because the project wouldn't be undertaken otherwise). 11ea856c_8b8a_73c6_9aec_913601252ed6_TB1222_00 11ea856c_8b8a_9ad7_9aec_ddfee0bfff90_TB1222_00 Cost of capital:
16.0%
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01234567NPVProduct: NPV x Prob.75% Good$750$750$750$750$750$750$750$528.92$369.69 -$2500
25% Bad$50$50$50$50$50$50$50-$2289.07-$574.52 Expected NPV if Go Now-$177.82 11ea856c_8b8a_9ad8_9aec_e3af0ef41f7f_TB1222_00 ? 11ea856c_8b8a_9ad9_9aec_2b6c5fcc888d_TB1222_00 ?

Norris Production Company (NPC)is Considering a Project That Has an Up-Front