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The Z-90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another one of its products, Z-45, becomes an industry standard. There is a 60% chance that the Z-45 will become the industry standard, in whihc case the Z-90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 40% chance that the Z-45 will not become the industry standard, in which case the Z-90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.
a. Based on the above information, what is the Z-90's expected net present value and coefficient of variation?
b. Now assume that one year from no SI will know if the Z-45 has become the industry standard, and will only invest in that case. The cash flows will be the same and will still be available for 5 years form the initial investment. Assuming that the cost of capital remains at 12%, what is the estimated value of this investment timing opition? What is the coefficient of variation of the projects cash flows with the option to wait? Is the overall risk of the project reduced with the introduction of the option (Yes/No)?
Describe the use of internal rate of return (IRR), net present value (NPV), and the payback method in evaluating project cash flows.
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