I saw a question that said a high risk project had a series of conditional probabilities of failure in the first 3 years. it also said to use a 25% discount rate due to the high risk. The explanation of the answer said to multiply the final years cash flow by the product of the conditional probabilities of success. why would you account for the high risk using the conditional probabilities of success AND a high discount rate? seems like you should use one or the other?
post the question, not really clear here what you are saying.
I dont have the question in front of me but here is a summary: an analyst is trying to decide whether to invest in a high risk project that has the following conditional probabilities of failing in the first 3 years year 1: 20% year 2: 25% year 3: 35% the analyst is using a discount rate of 25% due to the high risk of the project. the payoff in year 5 if successful is expected to be $5,000,000. What is the NPV of the project?
what’s the probability of success? * (payoff/1.25)^5 = NPV
(1-.2)(1-.25)(1-.35)(1-.00)(1-.00) = .39 % success in 5 years. 5000000 * .39 = 1950000 NPV = 1950000/(1.25)^5 = $638976 This is also assuming years 4 and 5 don’t have a probability of failure.
(1-.2)(1-.25)(1-.35)(1-.00)(1-.00) = .39 % success in 5 years. How did you do this? seems like you are saying success is independent event for each year.
The conditional failure probability is the probability that a venture investment will fail in any one year, given that it has survived until then. Probability of success (N years) = [(1-FP1)(1-FP2)…(1-FPN)] It goes into good detail in reading 76.
oh, wow, i haven’t read that reading, but i was good with concept, 
of computing this npv.
We’re 1.5 weeks from the test and you haven’t gotten that far with the readings? When did you start studying pepp?
Oh, I have about 50% of readings left! lol. I started studying beginning may.
why account for risk twice? with probaility of success and high discount rate?
You have to account for the probability of failure/success. And the 1.25 is to discount back to the present value.
the discount rate is high due to the high risk. they would have used a lower discount rate for a project that didn’t have as high a risk of failure in the first three years. the question is why use a high discount rate when you’ve already factored in the probability of failure?
Because, although the project may succeed, there is still a chance it could fail. I would just reference reading 76 for more detail…
chance it could fail = risk risk is taken into account in discount rate for all other npv questions. sorry to beat this to death but something is not clicking for me
ryanwtyler Wrote: ------------------------------------------------------- > I dont have the question in front of me but here > is a summary: > > an analyst is trying to decide whether to invest > in a high risk project that has the following > conditional probabilities of failing in the first > 3 years > > year 1: 20% > year 2: 25% > year 3: 35% > > the analyst is using a discount rate of 25% due to > the high risk of the project. the payoff in year > 5 if successful is expected to be $5,000,000. > What is the NPV of the project? First, calculate the probability of succes, as soxboys did: (1-.2)(1-.25)(1-.35)(1-.00)(1-.00) = 39 % probability of success in 5 years. The probability of failure would be = 1-probability of success=61% probability of failure in 5 years. NPV project = NPV success+ NPV failure = 39%*[(5,000,000/1.25^5) - initial investment] +69%*(- initial investment)