The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-foot sailboat based on the “winged” keels first introduced on the 12-meter yachts that raced for the America’s Cup.
First, YYC would have to invest $10,000 at t = 0 for the design and model tank testing of the new boat. YYC’s managers believe there is a 60% probability that this phase will be successful and the project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage value.
The next stage, if undertaken, would consist of making the molds and producing two prototype boats. This would cost $500,000 at t = 1. If the boats test well, YYC would go into production. If they do not, the molds and prototypes could be sold for $100,000. The managers estimate the probability is 80% that the boats will pass testing and that Stage 3 will be undertaken.
Stage 3 consists of converting an unused production line to produce the new design. This would cost $1 million at t = 2. If the economy is strong at this point, the net value of sales would be $3 million; if the economy is weak, the net value would be $1.5 million. Both net values occur at t = 3, and each state of the economy has a probability of 0.5. YYC’s corporate cost of capital is 12%.
- a. Assume this project has average risk. Construct a decision tree and determine the project’s expected
NPV . - b. Find the project’s standard deviation of NPV and coefficient of variation of NPV. If YYC’s average project had a CV of between 1.0 and 2.0, would this project be of high, low, or average stand-alone risk?
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Chapter 11 Solutions
Financial Management: Theory & Practice
- Jamie Williams, the project manager of Arc Systems Ltd. is evaluating a proposal to install solarpanels on the roof of its factory. The panels will cost $150,000 per set. Depending on the price ofelectricity and the efficiency of the panels, the project will increase operating cash flows by either$50,000 per year or $75,000 per year. The useful life of the panels is 5 years. If early resultsindicate savings of $75,000 per year, four additional sets of panels will be installed immediatelyat the same cost with the same projected savings. The probability of either outcome is 50%. Usinga discount rate of 10%:Required:i. Compute the expected NPV of the project if the option to expand is NOT considered. ii. Compute the expected NPV of the project if the option to expand is considered. iii. Why is it important to consider real options in the capital budgeting process? GiveONE (1) specific example.arrow_forwardMamafu is considering a proposal to manufacture high-protein cricket snacks. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next year's rental charge on the warehouse is $120,000, and thereafter the rent is expected to grow in line with inflation at 3% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.5 million. This could be depreciated for tax purposes over 10 years. However, Mamafu expects to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $500,000. Finally, the project requires an initial investment in working capital of $400,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of cricket snacks are expected to be $4 million, and thereafter sales are forecasted to grow by 4% a year, slightly faster than the inflation rate. Manufacturing costs are expected…arrow_forwardHaslam Homes is considering designing and marketing a concrete, yurt-based pre-fabricated home to compete in the doomsday prepper market. Development will cost $1,000,000 and will take one year. If the yurts are popular (30% probability) the cash flows will be $500,000 per year for 5 years starting in Year 1. If the yurts are not a hit (70% probability) the cash flows will be $100,000 per year for 5 years. Calculate the ENPV of the project. Haslam's cost of capital is 10%. -$137,212 -$150,934 -$166,027 correct answer -$182,630 -$200,893 DO NOT USE EXCELarrow_forward
- Abhaliyaarrow_forwardUnited Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental charge on the warehouse is $125,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.35 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $450,000. Finally, the project requires an immediate investment in working capital of $375,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $4.70 million, and thereafter, sales are forecasted…arrow_forwardUnited Pigpen (UP) is considering a proposal to manufacture high protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next year's rental charge on the warehouse is $190,000, and thereafter the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $2.3 million. This could be depreciated for tax purposes over 10 years. However, UP expects to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $760,000. Finally, the project requires an initial investment in working capital of $665,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $8.0 million, and thereafter sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected…arrow_forward
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- United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next year's rental charge on the warehouse is $120,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.32 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $440,000. Finally, the project requires an immediate investment in working capital of $370,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $4.60 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs…arrow_forwardAjax Investment Company is considering the purchase of land that could be developed into a class A office project. At the present time, Ajax believes that the site could support a 300,000 rentable square foot project with average rents of $20 per square foot and operating expensesequal to 40 percent of that amount. It also expects rents to grow at 3 percent indefinitely and believes that Ajax should earn a 12 percent return (r) on investment. The building would cost $100 per square foot to build:a. What would the estimated property value and land value be under the above assumptions?b. If rents are suddenly expected to grow at 4 percent indefinitely, what would the property value and land value be now? What percentage change in land value would this be relative to the land value in (a)?c. Instead of (b), suppose rents will grow by only 1 percent because of excessive supply. What would land value be now? What percentage change would this be relative to the land value in (a)?d. Suppose…arrow_forwardJohn Smith is looking to open an ice-cream parlor place in the neighborhood where he resides. He has been thinking about this project for a while. He has completed the technical, legal, and economic feasibility studies in order to decide properly. The economic study presented him with the following financial forecasts: The project will last 5 years. The price of an average creamery ice-cream cone should be $6 per unit. Under the current conditions, it is not expected that the price will change over the life of the project. The store is expected to sell 20,000 units the first year, with an annual growth of 5% in the units sold. The main variable costs are waffle cones, ice-cream, toppings, whipped cream, chocolate fudge, disposable cups, napkins and plastic spoons. The economic study has also found that the variable costs should be 40% of the sales revenues. The main fixed costs are rent ($10,000/year), utilities ($5,000/year), and gross salaries for two part-time employees…arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning