Chapter 13, Problem 10IC

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# 21ST CENTURY EDUCATION PRODUCTSOTHER TOPICS IN CAPITAL BUDGETING 21st Century Educational Products (21st Century) is a rap idly growing software company, and consistent with its growth, it has a relatively large capital budget Although most of the company’s projects are fairly easy to evaluate, a handful of projects involve more complex evaluations.John Keller, a senior member of the company’s finance staff, coordinates the evaluation of these more complex projects. His group brings their recommendations directly to the company’s CFO and CEO, Kristin Riley and Bob Stevens, respectively. a. In recent months, Keller’s group has focused on real option analysis. 1. What is real option analysis? 2. What are some examples of projects with real options? b. Considering real options, one of Keller’s colleagues, Barbara Hudson, has suggested that instead of investing in Project X today, it might make sense to wait 1 year because 21st Century would learn more about market conditions and would improve its forecast of the project's cash flows. Right now 21st Century forecasts that Project X will generate expected cash flows of $33,500 for 4 years. However, if the company waits 1 year, it will learn more about market conditions. There is a 50% chance that the market will be strong and a 50% chance that it will be weak. If the market is strong, the annual cash flows will be$43,500. If tire market is weak, the annual cash flows will be only $23,500. If 21st Century chooses to wait 1 year, the initial investment will remain$100,000, and cash flows will continue for 4 years after the initial investment is made. Assume that all cash flows are discounted at 10%. Should 21st Century invest in Project X today, or should it wait a year before deciding whether to invest in the project? c. Now assume that there is more uncertainty about the future cash flows. More specifically, assume that the annual cash flows are $53,500 if the market is strong and$13,500 if the market is weak. Assume that the upfront cost is still $100,000 and that the WACC is still 10%. Will this increased uncertainty' make the firm more or less willing to invest in the project today? Explain. d. 21st Century is considering another project, Project Y. Project Y has an up-front cost of$200,000 and an economic life of 3 years. If the company develops the project, its after-tax operating costs will be $100,000 a year, however, the project is expected to produce after-tax cash inflows of$180,000 a year. Thus, the project’s estimated cash flows are as follows: Year Cash Outflows Cash Inflows Estimated Project Cash Flows 0 ($200,000)$0 ($200,000) 1 (100,000) 180,000 80,000 2 (100,000) 180,000 80,000 3 (100,000) 180,000 80,000 1. The project has an estimated WACC of 10%. What is the project's expected NPV? 2. Although the project’s operating costs are fairly certain at 5100,000 per year, the estimated cash inflows depend critically on whether 21st Century’s largest customer uses the product. Keller estimates that there is a 60% chance that the customer will use the product, in which case the project will produce after-tax cash inflows of$250,000. Thus, its estimated project cash flows will be $150,000 per year However, there is a 40% chance that the customer will not use the product, in which case the project will produce after-tax cash inflows of only$75,000. Thus, its estimated project cash flows will be -$25,000. Write out the estimated cash flows, and calculate the project’s expected NPV under each of the two scenarios. 3. Although 21** Century does not have the option to delay the project, it will know 1 year from now whether the key customer has selected the product. If the customer chooses not to adopt the product, 21** Century has the option to abandon the project. If 21- Century abandons the project, it will not receive any cash flows after Year 1, and it will not incur any' operating costs after Year 1. Thus, if the company chooses to abandon the project, its estimated cash flow's will be as follows: Again, assuming a WACC of 10%, what is the project’s expected NPV if it abandons the project? Should 21st Century invest in Project Y today, realizing it has the option to abandon the project at t = 1? 4. Up until now, we have assumed that the abandonment option has not affected tile project’s WACC. Is this assumption reasonable? How might the abandonment option affect the WACC? e. Finally, 21st Century is also considering Project Z. Project Z has an up-front cost of$500,000, and it is expected to produce cash flows of $100,000 at the end of each of the next 5 years (t = 1, 2, 3, 4, and 5). Because Project Z has a WACC of 12%, it clearly has a negative NPV. However, Keller and his group recognize that if 21st Century goes ahead with Project Z today, there is a 10% chance that this will lead to subsequent opportunities that have an expected net present value at t = 5 equal to$3,000,000. At the same time, there is a 90% chance that the subsequent opportunities will have an expected negative net present value (-\$1,000,000) at t = 5. On the basis of their knowledge of real options, Keller and his group understand that the company will choose to develop these subsequent opportunities only if they appear to be profitable at t = 5. Given this information, should 21st Century invest in Project Z today? Explain your answer.

a)

Summary Introduction

To discuss: The meaning of real option analysis.

1.

A contract to purchase a financial asset from one party and sell it to another party on an agreed price for a future date is termed as Option.

Explanation

The meaning of real option analysis is as follows:

A real option takes place when the companyās mangers can influence on the riskiness and size of the cash flows of the project by way of undertaking various actions at the end of the projectās life...

2.

Summary Introduction

To discuss: The example of projects with real options.

b.

Summary Introduction

To discuss:  Whether the C Company has to invest in Project X at present or wait for one-year before deciding to invest in the project.

c.

Summary Introduction

To discuss:  Whether the increased uncertainty makes the company more or less willing to invest in the project at present.

d.

Summary Introduction

To discuss:  The expected NPV of the project.

1.

NPV is the variation between the present value of the cash outflows and the present value of the cash inflows. In capital budgeting, the NPV is utilized to analyze the profitability of a project or investment.

2.

Summary Introduction

To find:  The expected NPV of the project in each scenario.

3.

Summary Introduction

To find:  The expected NPV of the project.

4.

Summary Introduction

To discuss:  Whether the assumption is reasonable and ways in which the abandonment option affect the WACC.

e.

Summary Introduction

To find:  Whether the C Company has to invest in Project Z at present.

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