Diplomat.com is considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%.
-If Diplomat goes ahead with this project today, it will obtain
Knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5.
There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Diplomat.com does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
A) -$1,104,607
B) -$875,203
C) $199,328
D) $561,947
E) $898,205

Question

Quizplus · Accepted Answer

The estimated NPV of the project is calculated by considering both the initial project's cash flows and the expected value of the future opportunity. The NPV of the initial project is calculated using the cash flows and the cost of capital. The expected NPV of the future opportunity is calculated by multiplying the probability of each outcome by its respective NPV and discounting it back to the present value. The sum of these values gives the estimated NPV of the project.

DiplomatCom Is Considering a Project That Has an Up-Front Cost