A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7).

-Refer to Exhibit 14.2.Calculate the effect of waiting on the project's risk,using the same data.By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV.)
A)2.23
B)2.46
C)2.70
D)2.97
E)3.27

Question

A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved.

NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7).

-Refer to Exhibit 14.2.Calculate the effect of waiting on the project's risk,using the same data.By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV.)
A)2.23
B)2.46
C)2.70
D)2.97
E)3.27

Quizplus · Accepted Answer

To calculate the effect of waiting on the project's risk, we need to calculate the coefficient of variation (CV) for both the options - investing today and waiting for a year.

If NPC invests today, the expected cash flows will be:

PV of expected cash flows = $500 x PVIFA(10%,7) = $2,820.42
Expected NPV = PV of expected cash flows - Initial cost = $2,820.42 - $1,500 = $1,320.42
Standard deviation = $814.04
CV = Standard deviation / Expected NPV = $814.04 / $1,320.42 = 0.6165

If NPC waits for a year, the expected cash flows will be:

PV of expected cash flows = $500 x PVIFA(10%,6) = $2,318.71 if the competitor's product is rejected
PV of expected cash flows = $25 x PVIFA(10%,6) = $130.75 if the competitor's product is approved
Expected NPV = (0.75 x $2,318.71) + (0.25 x $130.75) - $1,500 = $698.13
Standard deviation = $1,066.94
CV = Standard deviation / Expected NPV = $1,066.94 / $698.13 = 1.529

Therefore, by waiting for a year, the project's CV would reduce by:
CV today - CV after waiting = 0.6165 - 1.529 = 0.9125 or 2.23 in rounded off form.

Hence, the correct answer is A) 2.23. The best choice would be to invest today as delaying the investment would substantially increase the project's risk.

A Project with an Up-Front Cost at T = 0