Chapter 26, Problem 3P

Wansley Lumber is considering the purchase of a paper company, which would require an initial investment of $300 million. Wansley estimates that the paper company would provide net cash flows of $40 million at the end of each of the next 20 years. The cost of capital for the paper company is 13%.

1. a. Should Wansley purchase the paper company?
2. b. Wansley realizes that the cash flows in Years 1 to 20 might be $30 million per year or $50 million per year, with a 50% probability of each outcome. Because of the nature of the purchase contract, Wansley can sell the company 2 years after purchase (at Year 2 in this case) for $280 million if it no longer wants to own it. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? Again, assume that all cash flows are discounted at 13%.
3. c. Wansley can wait for 1 year and find out whether the cash flows will be $30 million per year or $50 million per year before deciding to purchase the company. Because of the nature of the purchase contract, if it waits to purchase, Wansley can no longer sell the company 2 years after purchase. Given this additional information, does decision-tree analysis indicate that it makes sense to purchase the paper company? If so, when? Again, assume that all cash flows are discounted at 13%.