Scenario Diplomat
Diplomat.com is 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 Scenario Diplomat. If Diplomat.com 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 favourable, 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 unfavourable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Diplomat.com 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

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 an NPV of approximately -$895,203. The expected NPV of the future opportunity is calculated as (0.35 * $6 million) + (0.65 * -$6 million) = -$1.2 million. Discounting this back to present value at 10% gives approximately -$745,874. Adding these gives an estimated NPV of $199,328.

Scenario Diplomat Diplomat.com Is Considering a Project That Has an Up-Front Cost