You are given with the following information of two projects planned by your company when there is no consideration of the possible bad condition of economy. Two projects are of the same initial costs with $1 million.
Table 1: (in thousands)
|
Project
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
A
|
850
|
2720
|
- 250
|
1300
|
2800
|
|
B
|
1460
|
-375
|
1600
|
|
|
a) Suppose the cost of capital is 10% and the $1 million initial outlays are paid out by installments, that is, the $1 million initial outlays are present values for the regular payments each year, what is the Net Present Value for each project?
b) Suppose the financial manager discovered that if we postponed the project B to two years later, the cost of capital could be 9% due to possible low future interest rates. However, the deferment may cost the firm additional $350,000 to restart the facilities and the initial outlay must be spent now, instead of two years later. Will you recommend waiting for additional 2 years to start?
c) Let the corporate income tax rate be 30%, the cost of debts be 6%, the cost of equity be 25% and there is no preferred stock issued by the firm. Assuming the weighted average cost of capital is given as 12% in a), what is the debt-to-equity ratio for your company?
d) Find the IRR (Internal Rate of Return) for project A and project B. What is your decision based on the IRR criterion?
e) Let the initial outlays be increased to $1.5 million. Suppose there is a 40% chance that the market may be bad and the cash flows for both projects will change to
|
Project
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
Year 5
|
|
A
|
-650
|
720
|
-450
|
-2100
|
-500
|
|
B
|
160
|
1875
|
-1000
|
|
|
That is to say, the original cash flows in Table 1 only have 60% chance to happen. What is your decision for each project? What is the present value of the "Real Option" for each project if you can discontinue the projects when you find out that they may not be successful?