Reference no: EM131809550
On January 1, 20X1, Enterprise Company has the opportunity to invest in a project with an uncertain outcome. The product might be a hit and very profitable, or it might not. To put specific numbers to it, there is a 50 percent chance that the payoffs will be an annuity of $1,000 per year for three years. There is also a 50 percent chance that the payoffs will be an annuity of $500 per year for three years.
The payoff on December 31, 20X1 is when Enterprise discovers whether the product is a hit or not. If the payoff is $1,000, then the other years will also be $1,000. If the payoff is $500, then the other years will also be $500.
The alternative use of money is to invest it at 10 percent.
a. What is the present value of the expected value of the project?
b. As it happens, the land, building, and equipment have alternative uses, which means that anytime during the project Enterprise could stop the project and turn to a new project (project 2). If numbers were put to it, Enterprise anticipates that this possible other project has a present value of $1,500 as of the end of year 20X1. This means that Enterprise would have the new project (project 2) with a present value of $1,500 plus the $500 (or a total of $2,000) outcome if they switched projects on December 31, 20X1. What is the present value as of January 1, 20X1 of the first project including the option to move to the new project (project 2) at the end of 20X1?
c. What is the value as of January 1, 20X1 of being able to opt out of this first project if it turns out to have a low payoff? The value of this option is the increase in present value of part b. compared to part a. I think this is sometimes called the value of the abandonment option.
d. Does accounting have the possibility to tell you which path the company is on? That is, does accounting have the possibility to tell you whether the project is a hit or not? Elaborate.
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