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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

INVESTMENT TIMING OPTION Digital Inc. is considering the production of a new cell phone. The project will require an investment of $15 million. If the phone is well received, the project will produce cash flows of $10 million a year for 3 years; but if the market does not like the product, the cash flows will be only $2 million per year. There is a 50% probability of both good and bad market conditions. Digital can delay the project a year while it conducts a test to determine whether demand will be strong or weak. The delay will not affect the dollar amounts involved for the projectʹs investment or its cash flows—only their timing. Because of the anticipated shifts in technology, the 1-year delay means that cash flows will continue only 2 years after the initial investment is made. Digital’s WACC is 10%. What action do you recommend?

Summary Introduction

To Determine: The action that is recommended.

Introduction: The net present value is also termed as the discounted cash flow approach is a mainstream capital budget method that considers the time value of cash. It utilizes net present value of the investment as the base to accept or reject a projected investment in projects like buying of new machine, buying of stock or inventory etc.

Explanation

Determine the net present value

Using a excel spreadsheet, the net present value is determined as -$78,888.05.

Excel Spreadsheet:

Excel Workings:

Therefore the net present value at $6 million cash flow is $78,888.05

Determine the net present value of strong demand probability at wait for 1 year

Using a excel spreadsheet, the net present value of strong demand probability at wait for 1 year is determined as $2,141,247.18.

Excel Spreadsheet:

Excel Workings:

Therefore the net present value of strong demand probability at wait for 1 year is $2,141,247.18

Determine the net present value of weak demand probability at wait for 1 year

Using a excel spreadsheet, the net present value of weak demand probability at wait for 1 year is determined as -$10,480,841.47.

Excel Spreadsheet:

Excel Workings:

Therefore the net present value of weak demand probability at wait for 1 year is -$10,480,841.47

Determine the value of option at wait for 1 year

The net present value of weak demand is not considered because it has a negative net present value...

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