Lindley Corp. Is Considering A New Product That Would Require An Investment Of

Problem #1: Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below.  One of Tutor’s larger competitors, Online Professor (OP), is expected to do one of two things in Year 5:  (1) develop its own competing program, which will put Tutor’s program out of business, or (2) offer to buy Tutor’s program if it decides that this would be less expensive than developing its own program.  Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won’t be bought, and thus the program will simply be closed down with no salvage value.  What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?

 

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WACC = 10.0%                 0                1                2                3                4                5

Original project:             -$3,000        $500          $500          $500          $500           $500

 

Future                              Prob.

Buys                                 35%                                                                                $6,000

Doesn’t buy                      65%                                                                                       $0

 

Problem #2: Lindley Corp. is considering a new product that would require an investment of $10 million now, at t = 0.  If the new product is well received, then the project would produce after-tax cash flows of $5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $2 million per year.  There is a 50% probability that the market will be good.  The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak.  The project’s cost and expected annual cash flows would be the same whether the project is delayed or not.  The project’s WACC is 10.0%.  What is the value (in thousands) of the project after considering the investment timing option?

 Problem #3: 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%.What is the project’s NPV?

Problem #4: 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%. (See Problem above). 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?

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