When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at...

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When preparing capital budgeting analysis for a new project,Chris Johnson, a chief financial officer at BT Industries, faced adilemma. The project involved a production of new type of shippingcontainers, which were significantly more durable and had aconsiderably longer useful life compared to conventional containersused in the industry. The year was 2009, and the equipmentnecessary for producing the containers was being sold for $750K.Each year, this cost is expected to increase by 30%. The usefullife of the equipment and the project is 6 years. Mr. Johnsonestimated that during a recovery year, the project will generatenet cash flows of $500K per year, while during a recessionary year,the project will lose money, with an expected net cash flow of$-100K per year. Because the economy suffered a significant declinejust a year prior, there was uncertainty about the economy ingeneral, and, very much affected by the economy, the demand forshipping and containers. Market analysts predicted that 2010provide certain information about the likelihood of recovery. Atthis point, in 2009, the likelihood of 2010 being a recovery yearis estimated at 45% and the likelihood of 2010 being a recessionyear is estimated at 55%. If 2010 is a recovery year, thelikelihood that recovery continues in 2011 and all subsequent yearsis 80%, and the likelihood of these subsequent years beingrecessionary years is 20%. If recession continues in 2010, thelikelihood that 2011 and all subsequent years will be recoveryyears is 20%, and the likelihood of these subsequent years beingrecessionary is 80%. In 2011, the market gets resolved, andeveryone will know the state of the economy for the foreseeablefuture with certainty. Since he has not dealt with uncertaintyregarding the future state of the economy before, Mr. Johnson isbewildered and asks your help in determining the course of actionregarding this opportunity. In particular, should the firm buy theequipment in 2009, 2010, or not buy at all? Mr. Johnson hasestimated that the WACC for the company in certain times has been10%. Assume that the project has no tax implications, i.e. the taxrate of 0%. Also assume that the firm can shut down the project anytime at a one-time cost of $50K
. a) What is the NPV of investing into the machine in 2009? b) What is the NPV (in year 2009) of delayingthe investment until 2010? c) What is the NPV(in year 2009) of delaying the investment until 2011?__ d) What strategy with respect to this investmentshould the firm follow? In other words, when should the firminvest? Explain your answer.

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All financials below are in 000 We are looking at four different options Option 1 2010 is a recovery year and 2011 and all the subsequent years are also recovery years probability p1 45 x 80 36 Initial investment C0 750 Cash flow in all the six years 1 to 6 C 500 N 6 years Discount rate R 10 Hence NPV1 C0 C R x 1 1 RN 750 500 10 x 1 1 106 142763 Option 2 2010 is a recovery year and 2011 and all the subsequent years are also recessionary years probability p1 45 x 20 9 Cash flow in year 1 C1 500 Cash flows in each of the year 2 to 6 100 N 5 years of annuity Hence NPV2 C0 C1 1 R C R x 1 R x 1 1 RN 750 500 1 10 100 10 x 1 10 x 1 1 105 64007 Option 3 2010 is a recessionary See Answer

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When preparing capital budgeting analysis for a new project,Chris Johnson, a chief financial officer at BT Industries, faced adilemma. The project involved a production of new type of shippingcontainers, which were significantly more durable and had aconsiderably longer useful life compared to conventional containersused in the industry. The year was 2009, and the equipmentnecessary for producing the containers was being sold for $750K.Each year, this cost is expected to increase by 30%. The usefullife of the equipment and the project is 6 years. Mr. Johnsonestimated that during a recovery year, the project will generatenet cash flows of $500K per year, while during a recessionary year,the project will lose money, with an expected net cash flow of$-100K per year. Because the economy suffered a significant declinejust a year prior, there was uncertainty about the economy ingeneral, and, very much affected by the economy, the demand forshipping and containers. Market analysts predicted that 2010provide certain information about the likelihood of recovery. Atthis point, in 2009, the likelihood of 2010 being a recovery yearis estimated at 45% and the likelihood of 2010 being a recessionyear is estimated at 55%. If 2010 is a recovery year, thelikelihood that recovery continues in 2011 and all subsequent yearsis 80%, and the likelihood of these subsequent years beingrecessionary years is 20%. If recession continues in 2010, thelikelihood that 2011 and all subsequent years will be recoveryyears is 20%, and the likelihood of these subsequent years beingrecessionary is 80%. In 2011, the market gets resolved, andeveryone will know the state of the economy for the foreseeablefuture with certainty. Since he has not dealt with uncertaintyregarding the future state of the economy before, Mr. Johnson isbewildered and asks your help in determining the course of actionregarding this opportunity. In particular, should the firm buy theequipment in 2009, 2010, or not buy at all? Mr. Johnson hasestimated that the WACC for the company in certain times has been10%. Assume that the project has no tax implications, i.e. the taxrate of 0%. Also assume that the firm can shut down the project anytime at a one-time cost of $50K. a) What is the NPV of investing into the machine in 2009?__________________ b) What is the NPV (in year 2009) of delayingthe investment until 2010? __________________ c) What is the NPV(in year 2009) of delaying the investment until 2011?__________________ d) What strategy with respect to this investmentshould the firm follow? In other words, when should the firminvest? Explain your answer.