Garner-Wagner Incorporated
The executives of Garner-Wagner Inc.are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years.The project's cost of capital is 10%.
-Refer to the data for Garner-Wagner Incorporated.If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5).The company can decide at t = 5 whether or not it wants to pursue these additional opportunities.Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5.There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5.Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity.Instead, it can wait to see what the outlook is.However, the company cannot pursue the future opportunity unless it makes the $3 million investment today.What is the estimated net present value of the project, after consideration of the potential future opportunity?
A) −$1,104,607
B) −$875,203
C) $199,328
D) $561,947
E) $898,205

Question

Quizplus · Accepted Answer

The NPV of the initial project is calculated by discounting the cash flows of $500,000 for 5 years at 10%, which results in a negative NPV of approximately -$895,395. The expected NPV of the future opportunity is calculated by considering the probabilities: (0.35 * $6 million) + (0.65 * -$6 million) = -$1.2 million. Discounting this back to present value at 10% for 5 years gives approximately -$745,067. Adding these gives an estimated NPV of $199,328.

Garner-Wagner Incorporated The Executives of Garner-Wagner Inc.are Considering a Project That Has