it asks for optimal set of decisions, for me the original project should also be in the optimal set, i.e., use 40 to calculate but why in the answer, it uses the possibility based average NPV for the original one and highest cash flow for additional one? anyone has a clue?
Since it is really asking what is the NPV if you do the expansion project, you have to get the NPV of the base case. Then you have to calculate the NPV starting on YR 1 for the expansion project. With the probability of 50% for the project being done, you add this NPV amt to the base case. I found the Corp. Finance challenging. A lot of tiny detail calculations you have to watch out.
it is challenging, and lots of hidden assumptions as well!
is this the question related to the options? feeling lazy to pick up the book and check, right now. If so, on the basis on the pre-option NPV -> you have to do it based on the probability weighted after-tax cash flows. But for the “option” part - you realize that it will be realized (or become feasible) only when the higher cash flow is available. Otherwise, you would not choose to exercise the option.
Here is how I solved this: T(0)=-190 T(1)=.5(40)+.5(20)+(-190)*.5 So here you have a .5 chance of eaither CF from original project, and you can choose (if demand is high - .5 probability) to do the expansion T(2-10)=.5(80)+.5(20) I think you just need to break up each year’s cash flow and attach an appropriate probability
thanks guys, I will remember that it is just not making so much sense, since if you go ahead with the optimal option, it means it should be optimal situation in the first place right. anyway