Your firm is thinking of expanding. If you invest today, the expansion will generate $10 million in FCF at the end of the year, and will have a continuation value of either $148 million (if the economy improves) or $53 million (if the economy does not improve). If you wait until next year to invest, you will lose the opportunity to make $10 million in FCF but you will know the continuation value of the investment in the following year (that is, in a year from now you will know what the investment continuation value will be in the following year). Suppose the risk-free rate is 5%, and the risk-neutral probability that the economy improves is 40%. Assume the cost of expanding is the same this year or next year. a. If the cost of expanding is $82 million, should you do so today, or wait until next year to decide? b. At what cost of expanding would there be no difference between expanding now and waiting? To what profitability index does this correspond?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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Your firm is thinking of expanding. If you invest today, the expansion will generate $10 million in FCF at the end of the year, and will have a continuation value of either $148 million (if the economy improves) or $53 million (if the economy does not improve). If you wait until next year to invest, you will lose the opportunity to make $10 million in FCF but you will know the continuation value of the investment in the following year (that is, in a year from now you will know what the investment continuation value will be in the following year). Suppose the risk-free rate is 5%, and the risk-neutral probability that the economy improves is 40%. Assume the cost of expanding is the same this year or next year. a. If the cost of expanding is $82 million, should you do so today, or wait until next year to decide? b. At what cost of expanding would there be no difference between expanding now and waiting? To what profitability index does this correspond?
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