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Fundamentals of Financial Manageme...

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

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

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

INVESTMENT TIMING OPTION All American Telephones Inc. is considering the production of a new cell phone. The project will require an investment of $13 million. If the phone is well received, the project will produce cash flows of $8 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. All American 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 project’s 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. All American’s WACC is 8%. What action do you recommend?

Summary Introduction

To discuss: The action that the Person X recommended to the AT Company.

Explanation

Given information:

AT Company has decided to produce new call phone. This project needs an investment of $13,000,000. The cash flows of this project will be $8,000,000 a year for 3 years when the project run successfully and the cash flows of this project will be only $2,000,000 per year when the project run unsuccessfully. As a result, there is 50 percent probability of both good and bad market conditions. The WACC is 8 percent.

Compute the NPV:

The table below shows the Excel formula to calculate the NPV:

The table below shows the calculated values of the NPV:

Hence, the NPV is −$114,515.

Compute the NPV for waiting one year of a stronger demand:

The table below shows the Excel formula to calculate the NPV for waiting one year of a stronger demand:

The table below shows the calculated values of the NPV for waiting one year of a stronger demand:

Hence, the project’s NPV for waiting one year of a strong demand is $1,172,331.

Compute the NPV for waiting one year of a weak demand:

The table below shows the Excel formula to calculate the NPV for waiting one year of a weak demand:

The table below shows the calculated values of the NPV for waiting one year of a weak demand:

Hence, the NPV for waiting one year of a weak demand is −$8,734,695...

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