Answered: Companies often come across projects…

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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2. Growth options

Companies often come across projects that have positive NPV opportunities in which the company does not invest. Companies must evaluate the value of the option to invest in a new project that would potentially contribute to the growth of the firm. These options are referred to as growth options.

Consider the case of Mitata Co.:

Mitata Co. is considering a three-year project that will require an initial investment of $45,000. It has estimated that the annual cash flows for the project under good conditions will be $80,000 and $5,000 under bad conditions. The firm believes that there is a 60% chance of good conditions and a 40% chance of bad conditions.

If the firm is using a weighted average cost of capital of 13%, the expected net present value (NPV) of the project is . (Note: Round your answer to the nearest whole dollar.)

Mitata Co. wants to take a potential growth option into account when calculating the project’s expected NPV. If conditions are good, the firm will be able to invest $6,000 in year 2 to generate an additional cash flow of $21,000 in year 3. If conditions are bad, the firm will not make any further investments in the project.

Using the information from the preceding problem, the expected NPV of this project—when taking the growth option into account—is . (Note: Round your answer to the nearest whole dollar.)

Mitata Co.’s growth option is worth . (Note: Round your answer to the nearest whole dollar.)

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