All American Telephones Inc. is considering the productionof a new cell phone. The project will require an investment of $13 million. If the phone iswell received, the project will produce cash flows of $8 million a year for 3 years, but ifthe market does not like the product, the cash flows will be only $2 million per year. Thereis a 50% probability of both good and bad market conditions. All American can delay theproject a year while it conducts a test to determine whether demand will be strong or weak.The delay will not affect the dollar amounts involved for the project’s investment or its cashflows—only their timing. Because of the anticipated shifts in technology, the 1-year delaymeans that cash flows will continue only 2 years after the initial investment is made. AllAmerican’s WACC is 8%. What action do you recommend?
All American Telephones Inc. is considering the production
of a new cell phone. The project will require an investment of $13 million. If the phone is
well received, the project will produce cash flows of $8 million a year for 3 years, but if
the market does not like the product, the cash flows will be only $2 million per year. There
is a 50% probability of both good and bad market conditions. All American can delay the
project a year while it conducts a test to determine whether demand will be strong or weak.
The delay will not affect the dollar amounts involved for the project’s investment or its cash
flows—only their timing. Because of the anticipated shifts in technology, the 1-year delay
means that cash flows will continue only 2 years after the initial investment is made. All
American’s WACC is 8%. What action do you recommend?
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