654 Words3 Pages

Corporation FinanceBus 35200Case Study: Penelope | |
1. What is the NPV of the first generation phone project, ignoring both the possibility of investing in the second-generation project and the possibility of selling the equipment after two years?
We calculate the NPV by adding the yearly future free cash flows of the project discounted at a rate equal to the cost of equity. We use the CAPM formula to calculate the cost of equity, assuming a risk free rate of 10%, a β of 1.2 and the market risk premium of 8%. We got a cost of equity of 20%. Free cash flows are calculated using the formula EBIT x (1-TAX) + Depreciation – Capex – Change in NWC. The results are presented below:
The NPV of the first generation phone project, ignoring both the possibility of investing in the second-generation project and the possibility of selling the equipment after two years is ($3,154). Since the NPV is negative, this would not be a good investment.
2. If we ignore the option to invest in the second-generation phone, how valuable is the option to sell the equipment in the second year? Hint: First draw the decision tree for the project with the option to sell the equipment in the second year. Then, depending on whether the cash flow increases or decreases, find the value of the option at the end of the second year. What is the value of this option today (use arbitrage pricing in a binomial tree)? Would Penelope want to invest under this scenario?
Ignoring both the possibility of selling the equipment after two years and investing in the second-generation project, the NPV of the project will be ($3,154).
To value the option to sell the equipment in the second year and to calculate NPV of the project with the option we use a binomial tree valuation. We assume: * the cash flows would either increase by 64.9% or decrease by 39.3% over each period * the risk free

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