Students at Harvard University are interested in developing a 6th generation 3D printer. The project has a two-year life with an initial investment of $160,000 to fund a year-long development phase. At the end of a year, a further $85,000 is required for production. Cash inflows from sales will occur at the end of the second year. The Project Manager of this additive manufacturing development team at the university is very aware of the uncertainty about the amount of cash inflows as it is unclear whether the market will embrace such a new innovative device. The management team believes there is a 70 percent probability that the new device will be a success. They also believe that the direction of device will become more apparent over the next year. In particular, there is an 80 percent chance that the direction over the next year will continue over the subsequent year. If the device is initially a success and this direction continues in the next year, the payoff will be $465,000. If the device is a success but does not continue to be a success in the subsequent year, the payoff is $175,000. If the device is initially unsuccessful but reverses trend in the following year, the payoff is $225,000. If the device is initially not a success and this direction continues in the subsequent year, the payoff is - $115,000. Suppose also that the required return on projects of this type is 11 percent. i. Draw the decision tree. ii. Determine the expected NPV of the project. Show all appropriate calculations. iii. Now, consider the case where the Project Manager has the option to abandon the project after the first year. In this case, the second phase of the project would only proceed if the market direction is favorable over the first year. If the market direction is unfavorable, the team would abandon the project, since proceeding would cost $85,000. Calculate the NPV of this project with the option to abandon.
Students at Harvard University are interested in developing a 6th generation 3D printer. The project has a two-year life with an initial investment of $160,000 to fund a year-long development phase. At the end of a year, a further $85,000 is required for production. Cash inflows from sales will occur at the end of the second year. The Project Manager of this additive manufacturing development team at the university is very aware of the uncertainty about the amount of cash inflows as it is unclear whether the market will embrace such a new innovative device. The management team believes there is a 70 percent probability that the new device will be a success. They also believe that the direction of device will become more apparent over the next year. In particular, there is an 80 percent chance that the direction over the next year will continue over the subsequent year. If the device is initially a success and this direction continues in the next year, the payoff will be $465,000. If the device is a success but does not continue to be a success in the subsequent year, the payoff is $175,000. If the device is initially unsuccessful but reverses trend in the following year, the payoff is $225,000. If the device is initially not a success and this direction continues in the subsequent year, the payoff is - $115,000. Suppose also that the required return on projects of this type is 11 percent. i. Draw the decision tree. ii. Determine the expected NPV of the project. Show all appropriate calculations. iii. Now, consider the case where the Project Manager has the option to abandon the project after the first year. In this case, the second phase of the project would only proceed if the market direction is favorable over the first year. If the market direction is unfavorable, the team would abandon the project, since proceeding would cost $85,000. Calculate the NPV of this project with the option to abandon.
Chapter11: Cash Flow Estimation And Risk Analysis
Section: Chapter Questions
Problem 1bM
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