(a) Explain how the Fisher separation theory shows that, under certain conditions, shareholders can delegate to managers the task of choosing which physical investment projects to undertake. What specific conditions must hold for this to be true? (b) PJP, an industrial manufacturer, is considering a new capital investment project to make and produce and sell a new type of electrical generator. The first stage of the project requires an investment of $8,000 now for the initial design and market research. There is a 40% probability that this phase will be successful. If it is not successful (probability 60%), the project will be abandoned with zero salvage value. If the first stage is successful, a further investment of $300,000 will be required one year from now to make and test prototype generators. If this second stage is not successful (probability 55%), the prototypes could be sold for $40,000. If it is successful (probability 45%), PJP would go ahead and produce the generator. Further machinery for full production would cost $600,000 two years from now. The net cash flows from production and sales of the generator will be either $250,000 or $200,000 every year into perpetuity, depending on whether the demand is strong (probability 50%) or weak (probability 50%). Assume these cash flows occur at the year ends with the first of them occurring three years from now. PJP's cost of capital is 10%. Assume investors are risk-neutral. Construct a decision tree and determine the expected Net Present Value of the project. Should the project be undertaken?
(a) Explain how the Fisher separation theory shows that, under certain conditions, shareholders can delegate to managers the task of choosing which physical investment projects to undertake. What specific conditions must hold for this to be true? (b) PJP, an industrial manufacturer, is considering a new capital investment project to make and produce and sell a new type of electrical generator. The first stage of the project requires an investment of $8,000 now for the initial design and market research. There is a 40% probability that this phase will be successful. If it is not successful (probability 60%), the project will be abandoned with zero salvage value. If the first stage is successful, a further investment of $300,000 will be required one year from now to make and test prototype generators. If this second stage is not successful (probability 55%), the prototypes could be sold for $40,000. If it is successful (probability 45%), PJP would go ahead and produce the generator. Further machinery for full production would cost $600,000 two years from now. The net cash flows from production and sales of the generator will be either $250,000 or $200,000 every year into perpetuity, depending on whether the demand is strong (probability 50%) or weak (probability 50%). Assume these cash flows occur at the year ends with the first of them occurring three years from now. PJP's cost of capital is 10%. Assume investors are risk-neutral. Construct a decision tree and determine the expected Net Present Value of the project. Should the project be undertaken?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Question 1
(a) Explain how the Fisher separation theory shows that, under certain conditions,
shareholders can delegate to managers the task of choosing which physical
investment projects to undertake. What specific conditions must hold for this
to be true?
(b) PJP, an industrial manufacturer, is considering a new capital investment
project to make and produce and sell a new type of electrical generator.
The first stage of the project requires an investment of $8,000 now for the initial
design and market research. There is a 40% probability that this phase will be
successful. If it is not successful (probability 60%), the project will be
abandoned with zero salvage value.
If the first stage is successful, a further investment of $300,000 will be required
one year from now to make and test prototype generators. If this second stage is
not successful (probability 55%), the prototypes could be sold for $40,000. If it
is successful (probability 45%), PJP would go ahead and produce the generator.
Further machinery for full production would cost $600,000 two years from now.
The net cash flows from production and sales of the generator will be either
$250,000 or $200,000 every year into perpetuity, depending on whether the
demand is strong (probability 50%) or weak (probability 50%). Assume these
cash flows occur at the year ends with the first of them occurring three years
from now. PJP's cost of capital is 10%. Assume investors are risk-neutral.
Construct a decision tree and determine the expected Net Present Value of the
project. Should the project be undertaken?
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