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+ 2 3 4. Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. 5 There is a 30 percent probability of good conditions, in which case the project will provide a cash flow of $9 million 6 at the end of each year for 3 years. There is a 40 percent probability of medium conditions, in which case the annual 7 cash flows will be $1 million, and there is a 30 percent probability of bad conditions and a cash flow of $1 million per 3 year. BSi uses a 12 percent cost of capital to evaluate projects like this. 9 10 11. n. Find the project's expected cash flows and NPV. 12 13 WACC- 12% 14 15 Condition Probability CE CE x Prob 16 Good 30% 59 17 Medium 40% 54 18 Bad 30% 51 19 Expected CF- 20 21 Time line of Expected CF 2 2 0 1 2 3 $10 24 25 NPV- 25 As a CFO, would you accept or reject this project? Briefly explain. Tb. Now suppose the BSI can abandon the project at the end of the first year by selling it for $6 million taka, salvage value, equal to book value). BSI will still receive the Year 1 cash flows, but will receive no 3. cash flows in subsequent years. Assume the salvage value is risky and should be discounted at the WACC. 12% 6% $6 Salvage Value 5 WACC- 7 Risk-free rate- 3 Decision Tree Analysis D 1 Cost 0 Probability 3 1 5 30% $10 40% 7 30% Future Cash Flows 2 NPV this Scenario Probability x NPV 1 3 Expected NPV of Future CFS As a CFO, would you accept or reject this project? Briefly explain. c. Now assume that the project cannot be shut down. However, expertise gained by taking it on will lead to an opportunity at the end of Year 3 to undertake a venture that would have the same cost as the original project, and the new project's cash flows would follow whichever branch resulted for the original project. In other words, there would be a second $10 million cost at the end of Year 3, and then cash flows of either $9 million, 54 million, or Simillion for the following 3 years. Use decision tree analysis to estimate the value of the project, including the opportunity to implement the new project in Year 3. Assume the $10 million cost at Year 3 is known with certainty and should be discounted at the risk free rate of 6 percent. Hint to help separate the costs of capital, you can do one decision tree for the operating cash flows and one for the cost of the project, then sum their NPVS. WACC- Risk-free rate 12% 6% 56 57 WACC- Risk free rate 123 6% 1 Upfront Cost & Future Operating Cash Flow (Discount at WACC) 5 6 NPV this Prob. Scenario XNPV 9 Decision Tree Analysis Cost 1 0 Probability 2 3 -1 30% 5 $10 40% 30% Het wow would neerupeat or project with negitt Nov o How would opet poject with rega Expected NPV of Future Operating C Future Cost of Implementing Additional Project (Discount at Risk free rate) Probability 1 6 O NPV this Prob. Scenario x PV 4 5 30% 40% 30% Expected NPV of Future Operating CFS 88 89 Expected NPV of Future Operating CFS- 90 91 Total NPV (NPV of Future Operating CF plus NPV of Future Year 3 cost of implenting additional project) - 92 93 As a CFO, would you accept or reject this project? Briefly explain. 34 95 96 97 38 d. Now suppose the original (no abandonment and no additional growth project could be delayed a year. All the 39 cash flows would remain unchanged, but information obtained during that year would tell the company exactly which set of demand conditions existed. Use decision tree analysis to estimate the value of the project if it is delayed by 1 year. Hint: Once again, discount the $10 million cost at the risk.free rate since it is known with certainty. Show 01 02 two time lines, one for operating cash flows and one for the cost, then sum their NPVS. 03 WACC- 12% 04 Risk free rate- 05 06 Decision Tree Analysis: Optg. CFS Future Operating Cash Flows 07 (Discount at WACC) NPV this Probability 08 0 Probability 1 2 4 Scenario X NPV 09 10 11 30% 00 6% 00 WTCremer OES COMMY by 1 year. Hint: Once again, discount the $10 million cost at the risk free rate since it is known with certainty. Show TEPITETTY 01 02 two time lines, one for operating cash flows and one for the cost, then sum their NPVN. 03 WACC- 12% Risk-free rate 6% 35 06 Decision Tree Analysis: Optg. CFS Future Operating Cash Flows 37 (Discount at WACC) NPV this Probability 18 0 Probability 1 2 3 4 Scenario x NPV 09 10 11 30% 2 40% 3 30% 4 5 Expected PV of Future CFS G 7 Decision Tree Analysis: Costs Future Cost of Implementation Cost Discount at Risk Free Rate) NPV this Probability Probability 1 2 Scenario O X NPV 30% 40% 30% Expected PV of Future CFS 128 Total NPV (NPV of Future Operating CF plus 129 NPV of Future Year 1 cost of implenting additional project) 130 131 As a CFO, would you accept or reject this project? Brielly explain. 132 133 134 135. Look at your answers for parte (growth) and part d (delay). You've calculated the expected NPV for each. Now. 136 calculate (a) the standard deviation of the NPV Tor each and (b) the coefficient of variation (CV) for each alternative 137 and quantify them below. Considering the risk/return tradeoll, which is the preferred approach? 138 139 Hint: be sure to account for both cash flow components in each real option scenario Guidance for your calculations is included 140 Part c: Growth Prob NPV, each scenario Delta Delta2 D^2x Prob 141 E(NPV) - 142 Std Dev(NPV) 143 CV- 144 Vananca 145 146 Part d: Delay/Timing E(NPV) - 148 Std Dev(NPV) - 149 CV- 50 Variance 151 Preferred approach considering risk - 62 53 + 147

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