2.

4 Capital Budge0ng and Risk Analysis

 CONTENTS
2.4.1 Risk and the Investment Decision
2.4.2 Incorpora0ng Risk into Capital Budge0ng
2.4.2.1 Breakeven Cash Inflow
2.4.2.2 Risk-Adjusted Discount Rates
2.4.2.3 Certainty Equivalents
2.4.2.4 Simula0on
2.4.2.5 Sensi0vity and Scenario Analysis
2.4.2.6 Probability Trees
2.4.3 Real Op0ons in Capital Budge0ng
 Risk and the Investment Decision
•  Previously discussed capital budgeting techniques
weren’t able to consider the ff:
–  project cash flows typically have different levels of risk
–  acceptance of a project affects the firm’s overall risk

•  Risk in capital budgeting is the uncertainty

surrounding the future cash flows that a project
will generate OR the degree of variability of cash
flows
 Incorpora0ng Risk into Capital Budge0ng

A variety of tools exist to assist managers in

understanding the sources of uncertainty of
a project’s cash flows
1.  Break-even cash inflow
2.  Risk-Adjusted Discount Rates
3.  Certainty Equivalents
4.  Simulation
5.  Sensitivity Analysis
6.  Scenario Analysis
7.  Probability Trees
 1. Breakeven Cash Inflow
•  Breakeven cash flow (BECF)- minimum level of cash
inflow necessary for a project to be acceptable, that is
NPV = 0

•  the higher the BECF, the higher the operating risk of

project
•  Uncertainty surrounding future cash flows doesn’t affect
the BECF computation
1. Breakeven Cash Inflow
•  ACYFMG is considering 2 mutually exclusive
revenue-enhancing projects as follows:
–  A 5-year project with a P125,000 initial outlay
–  A 7-year project with initial investment of P160,000
•  If cost of capital is 11%, BECF for the projects
are:
–  5-year:(125,000 x 11%)/ [1-(1/(1.115))] = P33,821.29
–  7-year: (160,000 x 11%)/ [1-(1/(1.117))] =P33,954.44
•  If ACYFMG is risk-averse, it should select the 5-
year project
 Break-Even Point (BEP)
A type of analysis used to identify the level of sales
needed to meet the costs associated with a project

Break-even point (BEP) is level of output where all

operating costs (fixed and variable) are covered.

1)  Accounting BEP- to cover total operating cost (both cash

and depreciation) and produce zero NOI or EBIT
2)  Cash BEP- to cover cash operating costs
3)  NPV BEP- to cover present value of all its expenses over the
life of an investment
 Break-even points

BEPNPV = using trail and error to determine no. of

units produced and sold in order to make NPV = 0

NOTE: BEP is in number of units, hence, it is round-

up to the nearest whole number
 Break-even Point
Income Statement for selling 10,000 units
Sales P 500,000
Cost of goods sold 280,000
Gross profit P220,000
Fixed opera0ng expenses (of which P45,000 is 130,000
deprecia0on expense)
EBIT P 90,000
Taxes (30%) 27,000
NOPAT P 63,000
accounting BEP is 5,910 units
= 130,000 / (50 - 28)
cash BEP is 3,864 units
= (130,000 – 45,000)/ (50-28)
 NPV BEP
If the 5-year project have P55,000 initial
outlay and salvage value of P5,000, the
NPV break-even using 10% discount rate
and 30% tax rate is 2,642 (exact: 2,641.92
using trail and error approach or excel
goal seek function)

BEPNPV = using trail and error to determine no. of

units produced and sold in order to make NPV = 0

10
 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Sales 132,096 132,096 132,096 132,096 132,096
Cost of sales 79,258 79,258 79,258 79,258 79,258
Gross profit 52,838 52,838 52,838 52,838 52,838
Fixed cash 40,000 40,000 40,000 40,000 40,000
Depreciation 10,000 10,000 10,000 10,000 10,000
NOI 2,838 2,838 2,838 2,838 2,838
Taxes (30%) 852 852 852 852 852
NOPAT 0 3,690 3,690 3,690 3,690 3,690
plus: Dep 0 10,000 10,000 10,000 10,000 10,000
Initial outlay -55,000 0 0 0 0 0
Salvage value 0 0 0 0 0 5,000
FCF -55,000 13,690 13,690 13,690 13,690 18,690

PV of FCF @ 10% -55,000 12,445 11,314 10,285 9,350 11,605

NPV 0
Units sold 2,642
2. Risk-Adjusted Discount Rate (RADR)
•  aka Risk-Adjusted Cost of Capital
•  RADR is the rate of return that must be
earned, given the project’s riskiness, to
compensate the firm’s owners adequately
•  The higher the risk of a project, the
higher the RADR—and thus the lower a
project’s NPV.

12
 Project Cost of Capital
Firm-wide WACC can bias investment decisions
toward risky projects
2. Risk-Adjusted Discount Rate (RADR)
•  CAPM Model, which only reflects non-diversifiable
risk, provides a “rough estimate”

•  We will use CAPM to link risk (risk index) and RADR

•  Risk index is determined for each project

RADRproject= Rf + Risk Indexproject [Rm – Rf]

Risk-Adjusted Discount Rate (RADR)
•  ACYFMG is considering two mutually exclusive projects,
X and Y. ACYFMG’s overall cost of capital is 12%, the
market return is 15% and the risk-free rate is 5%.
ACYFMG estimates that the beta for project X is 1.10
and the beta for project Y is 1.70.

•  Project X’s RADR is 16%

= 5% + [1.10 x (15% – 5%)]

•  Project Y’s RADR is 22%

= 5% + [1.70 x (15% – 5%)]
Risk-Adjusted Discount Rate (RADR)
•  Both projects have initial investment of P50,000.
Project X have P16,800 annual cash inflows for 5 years
while project Y have P19,200 annual cash inflows for 5
years.

NPV of project X and project Y using firm-wide WACC and

RADR are as follows:

Project X Project Y
NPV @ 12% 10,560.24 19,211.70
NPV @ RADR 5,008.13 4,981.88
 3. Certainty Equivalents
•  Technique that adjusts the risky after-tax cash
flows to certain cash flows.
•  The greater the risk associated with a
particular cash flow, the smaller the CE factor
(in %)

Risky Certainty Certain

Cash X Equivalent = Cash
Flow Factor Flow
 3. Certainty Equivalents
•  Steps:
1)  Adjust all after-tax cash flows by certainty
equivalent factors to get certain cash flows.
2)  Discount the certain cash flows by the risk-free rate
of interest.

n
NPV = Σt=1
Certain CFt
(1 + Rf) t
- CF0

18
 Certainty Equivalents
ACYFMG is considering a new project that their research division has
proposed and have decided to use the certainty equivalent approach
to evaluate it. The expected cash flows and the estimated certainty
equivalent coefficients associated with this project are as follows:
Year Expected Certainty Equivalent
Cash Flows Coefficients
0 -P71,000 1.00
1 18,000 .90
2 28,000 .80
3 38,000 .70
4 28,000 .60
5 18,000 .50

ACYFMG’s WACC is 12% while risk-free rate is 6.5%.

19
 Certainty Equivalents
ACYFMG’s new project’s NPV using certainty equivalent is
P5,609.18 computed as:

Year Certain CF PV @ 6.5%

0 -71,000 x 1.0= -71,000 -71,000
1 18,000 x 0.9= 16,200 15,211.2676
2 28,000 x 0.8= 22,400 19,749.1679
3 38,000 x 0.7= 26,600 22,020.7858
4 28,000 x 0.6= 16,800 13,059.0279
5 18,000 x 0.5= 9,000 6,568.9275
NPV P 5,609.18
 Illustra0ve: BECF, RADR and CE
Riskscape Inc. is evalua0ng a project with the following
data: Ini0al Investment 2,500,000
Project Life 3 years
Annual Cash Flow 1,315,000
Beta 1.4
Certainty Equivalent Factors Yr. 1: 90%
Yr. 2: 85%
Yr. 3: 80%

Riskscape’s cost of capital is 12%. Risk-free rate and

market premium are 5% and 9%, respec0vely.
Compute for the project’s BECF, RADR, RADR NPV
and CE NPV.
21
 4. Simula0on Analysis
•  A statistics-based behavioral approach that applies
predetermined probability distributions and
random numbers to estimate risky outcomes

•  Simulation analysis generates thousands of

estimates of NPV that are built upon thousands of
values for each of the investment’s value drivers.

•  Value drivers- are basic determinants of an

investment’s cash flows such as market share,
market size, price, variable costs and cash fixed
costs.
NPV Simula0on (cont.)
 Probability Distribu0on of NPVs
Simulation’s fundamental appeal is that it provides decision
makers with a probability distribution of NPVs (continuum of
risk-return trade-offs) rather than a single point estimate of
the expected NPV.
 5. Sensi0vity Analysis
The process of determining how the
distribution of possible net present values or
internal rates of return for a particular
project is affected by a change in one
particular value driver.

Sensitivity analysis involves calculating the NPVs

for various deviations from a “expected or base
case” set of assumptions.
 Sensi0vity Analysis
Year 0 Years 1-4 Year 5
Revenues (200,000 units) 5,000,000 5,000,000
Less: Variable cost -3,600,000 -3,600,000
Less: Cash fixed cost -400,000 -400,000
Less: Depreciation
expenses -300,000 -300,000
Net operitng income 700,000 700,000
Less: Taxes (30%) -210,000 -210,000
NOPAT 0 490,000 490,000
Plus: Depreciation 0 300,000 300,000
Initial investment -1,800,000 0 300,000
Change in working capital -500,000 0 500,000
FCF -2,300,000 790,000 1,590,000

NPV @ 12% 1,001,714.68

IRR 26.65%

Compute for change/s in NPV if: unit sales (+5%), sales price (+5%),
variable cost per unit (+5%) and cash fixed cost (+5%)
 Sensi0vity Analysis
The following table shows the impact on NPV of changes in the
value drivers.
Expected 1,001,714.68 26.65%

Value Drivers Revised NPV % Change Revised IRR

Unit Sales (+5%) 1,178,348.72 +18% 29.15%
Price per unit (+5%) 1,632,550.52 +63% 35.46%
Variable cost (+5%) 547,512.88 -45% 20.13%
Cash fixed cost (+5%) 951,247.82 -5% 25.94%

From this we can conclude that project’s NPV is most sensitive to

changes in the selling price and variable cost. Thus management must
make sure that the estimates on these value drivers are accurate and
that these two value drivers are closely monitored.
 6. Scenario Analysis
An analysis that allows the financial manager to
simultaneously consider the effects of changes in
estimates of multiple value drivers on the
investment opportunity’s NPV
Scenario analysis is a more complex form of
sensitivity analysis.

Rather than adjusting one assumption (value driver)

at a time, analysts calculate the project NPV when
a whole set of assumptions changes in a particular
way to determine different scenarios (e.g. best
case and worst case scenarios)
 Scenario Analysis
Year 0 Years 1-4 Year 5
Revenues (200,000 units) 5,000,000 5,000,000
Less: Variable cost -3,600,000 -3,600,000
Less: Cash fixed cost -400,000 -400,000
Less: Deprecitation
expenses -300,000 -300,000
Net operitng income 700,000 700,000
Less: Taxes (30%) -210,000 -210,000
NOPAT 0 490,000 490,000
Plus: Depreciation 0 300,000 300,000
Initial investment -1,800,000 0 300,000
Change in working capital -500,000 0 500,000
FCF -2,300,000 790,000 1,590,000

NPV @ 12% 1,001,714.68

IRR 26.65%
Compute for NPV under best/worst scenario: unit sales (+/-5%), sales
price (+/-5%), variable cost per unit (-/+5%) and cash fixed cost (-/
+5%)
29
 Scenario Analysis
Expected or
Worst Case Base Case Best Case
Unit Sales 190,000 200,000 210,000
Price 23.75 25 26.25
Variable cost 18.9 18 17.1
Cash fixed cost 420,000 400,000 380,000

NPV (256,171.97) 1,001,714.68 2,368,105.10

-126% 136%

From the analysis, we can conclude that this is a risky investment because
NPV negative at worst case scenario but more than doubled at best case

30
 7. Probability Trees
•  A probability tree (or decision tree)
is a visual representation of the
sequential choices that managers
face over time with regard to a
particular investment.
!  The value of decision trees is that they force analysts
to think through a series of “if-then” statements that
describe how they will react as the future unfolds.
!  To work through a decision tree, begin calculation of
expected NPV at the end and then work backward to
the to evaluate today’s decision.
 Probability Tree
•  A fast food chain is deciding whether spend P675,000 to
test market acceptability of a branch at a new location
•  If consumer acceptance is high (50% chance), the fast
food chain may spend an additional P1.3M one year later
to open the branch at the new location. The company
predicts that the new branch will generate net cash
inflows of P550,000 per year for 12 years after opening
the branch.
•  If consumers respond less favorably in the market test,
the fast food chain will not proceed with opening the new
branch.
•  Cost of capital is 15%.
32
Probability Tree
Year 0 Year 1-13
Favorable and open
50% CF (1) = -1.3M
CF (2-13) = 550,000/ yr
Test
(-675,000)

50% Not favorable

Test market or not
CF = nil

Not test
(nil)
Probability Tree
Year 0 Year 1-13
Favorable and open
50% CF (1) = -1.3M
CF (2-13) = 550,000/ yr
Test
(-675,000) NPV = 1,681,340.45

50% Not favorable

Test market or not
CF = nil

NPV = nil
Not test
(nil)

Expected NPV test = -675,000 + 50% (1,681,340.45/1.15) + 50%(0/1.15)

= P56,017.59 ! test market
Illustrative: Probability Tree
You are given the opportunity to play a game of high stakes
gambling. The game begins by you paying an entry fee of
P35,000,000 followed by a fair coin toss. If the coin toss is “heads”
then you have an 80% probability of receiving a perpetuity of
P10,000,000 per year star0ng next year and a 20% probability of
receiving a perpetuity of P1,000,000 per year star0ng next year. If
the coin toss is “tails” you can con0nue to play but you will lose
P50,000,000 with certainty. Alterna0vely, you can make a make an
opt-out payment of P10,000,000 aher a “tail” to prevent you from
going down such a costly path. Assume that the proper discount
rate for the perpetual cash flow is 10%. Using the decision tree
approach, what is the present value of playing such a game?

35
 Real or Strategic Op0ons
in Capital Budge0ng
Opportunities that allow for the alteration of the
project’s cash flow stream while the project is being
operated

Embedded options arise naturally from investment.

Value of a project equals value captured by NPV,

plus value of option.
 Types of Real Op0ons
•  option to delay project until
Timing
estimated future cash flows are
options more favorable

Expansion •  option to increase the scale and

scope of an investment in response
options to realized demand

Contract,
Shut-down, •  options to slow down production,
and halt production temporarily, or stop
production permanently
Abandonment
(abandonment)
options
 Types of Real Op0ons
Follow-on
investment •  Similar to expansion options, but
more complex (Ex: movie rights to
options sequel)

•  Ability to use multiple production

Flexibility inputs (example: dual-fuel
options industrial boiler) or produce
multiple outputs
 Recognizing Real Op0ons
Given the following information for a 5M restaurant:
•  Perpetual annual cash flow:
–  if favorably received = P650,000
–  if not favorably received = P250,000
•  Probability of being favorably received = 50%
•  Discount rate = 10%
•  Option to build up to 10 restaurants if the project is
favorably received and will not build any additional
restaurants if it is not favorably received.
Use the PV of perpetuity equation (given by CF/r) to
determine the expected net present value with and
without the option.
 Recognizing Real Op0ons

P(favorable)
=50% NPV= P1,500,000
=[(650,000/10%)-5M]
Expected NPV to
build (without
op0on)=-500,000
NPV = -P2,500,000
P(Unfavorable)
[(250,000/10%)-5M]
=50%
 Recognizing Real Op0ons

P(favorable)
=50% Build up to 10 restaurants
NPV =10 x
[(650,000/10%)-5M]= 15M
Expected NPV to build
(with op0ons)= P6,250,000
Build only 1 restaurant
NPV =
P(Unfavorable)
[(250,000/10%)-5M]=
=50% -2.5M
 Recognizing Real Op0ons
Expected NPV (without option)
= [(50%)(P1,500,000)] + [(50%)(-P2,500,000)]
= -P500,000

Expected NPV (with option)

= [10 (50%)(P1,500,000)] + [(50%)(-P2,500,000)]
= P6,250,000
Recognizing Real Op0ons
Value of
NPV (w/o NPV (with
Expansion
op0ons) op0ons)
Op0on

-500,000 ? 6,250,000

P 6,750,000
 Illustra0ve: Real Op0ons
A celebrity was offered a two-year exclusive
contract by his current network for P3,000,000
annually. If he accept the contract, the network
retains the rights and he will not be able to
accept projects of other network during the
contract period. He was also offered a non-
exclusive contract at a price of P2,000,000 per
year wherein he will be allowed to accept
projects of other networks. What is the value of
the op0on to accept projects from other
networks during the two-year contract? Assume a
discount rate of 5%.
44
 CONTENTS
2.4.1 Risk and the Investment Decision
2.4.2 Incorpora0ng Risk into Capital Budge0ng
2.4.2.1 Breakeven Cash Inflow
2.4.2.2 Risk-Adjusted Discount Rates
2.4.2.3 Certainty Equivalents
2.4.2.4 Simula0on
2.4.2.5 Sensi0vity and Scenario Analysis
2.4.2.6 Probability Trees
2.4.3 Real Op0ons in Capital Budge0ng
 Key Takeaways
•  ?
End of 2.4
Prepare for Quiz 3
Knowledge Check
 KC: True or False
1.  When a project’s NPV is nega0ve, it will not have a
discounted payback period because the ini0al
investment will be unrecoverable.
2.  The NPV and IRR conflict in ranking projects may be
due to their differing assump0on on reinvestment of
intermediate cash inflows.
3. Simula0on is a more complex form of sensi0vity
analysis
4. Capital ra0oning is the situa0on in which a firm can
raise only a specified, limited amount of capital
regardless of how many good projects it has.
5. Op0ons can transform a project’s posi0ve NPV into
nega0ve NPV
49
 KC: True or False
6. A conflict will exist between the NPV and IRR methods, when
used to evaluate two projects, if the projects' cost of capital is
higher than the crossover rate of the two projects.
7. The greater the risk associated with a par0cular cash flow, the
larger its Certainty Equivalent factor.
8. An increase in the firm's WACC would have no impact on its
IRR. However, this could change the accept/reject decision
under the IRR method.
9. Profitability index allows comparison of the rela0ve
desirability of projects that require differing ini0al
investments
10. The NPV of a project whose large cash flows are received
early in the project’s life will be more sensi0ve to changes in
the discount rate than the NPV of a project whose cash flows
come in later in its life.
 KC: Mul0ple Choice
11. Sensi0vity and Scenario analysis both evaluates the
effect of changing value drivers on the project’s NPV;
their difference is that Sensi0vity analysis involves
changing ___ while Scenario analysis involves
changing ____.
A. the discount rate, the cash flows
B. The cash flows, the discount rate
C. one value driver, mul0ple value drivers
D. mul0ple value drivers, one value driver

51
 KC: Mul0ple Choice
12. When a project’s NPV is posi0ve, its
profitability index is greater than ___ and its
IRR is ____ its cost of capital

A. 0.0, greater than

B. 0.0, less than
C. 1.0, greater than
D. 1.0, less than

52
 KC: Mul0ple Choice
13. Deficiencies associated with using the
payback method to evaluate investment
alterna0ves include:

A. Cash flows aher the payback period are ignored

B. Fails to take into account the 0me value of money
C. Ignores the project’s overall profitability
D. All of the above

53
 KC: Mul0ple Choice
14. The accountant of AT, Inc. has prepared an analysis of a
proposed capital project using net present value technique.
The manager has ques0oned the accuracy of the results
because the discount factors employed in the analysis are
based on the assump0ons that the cash flows occurred at the
end of the year when they actually occurred uniformly
throughout each year. The net present value calculated by
the accountant
A. will be slightly overstated
B. will be slightly understated
C. will be misleading because the correc0on can reverse a posi0ve
NPV into a nega0ve NPV
D. will not need correc0on because the 0ming of cash flows does not
mater in NPV calcula0on
54
 KC: Mul0ple Choice
15. In capital budge0ng analysis, the “payback
reciprocal” may provide a quick and useful es0mate
of the internal rate of return only when
A. Cash inflows do not extend beyond the length of the payback
period
B. Most of the cash inflows from an investment precede the
investment outlay
C. The investment outlays are made uniformly throughout the life
of the investment
D. Cash inflows are uniform throughout the life of an investment
which is long rela0ve to its payback period
55
 KC: Mul0ple Choice
16. When the cost of capital of a project
decreases, its profitability index will:

A. increase
B. decrease
C. be the same
D. may increase or decrease

56
 KC: Mul0ple Choice
17. If the internal rate of return on an
investment is zero:
A. its NPV is posi0ve
B. Its future cash flows equal its ini0al investment.
C. it is generally a wise investment.
D. its cash flows decrease over its life.

57
 KC: Mul0ple Choice
18. Which of the following problem does
Modified IRR resolves?
A. Mul0ple IRR
B. Nonexistent IRR
C. Time disparity
D. Scale disparity

58
 KC: Mul0ple Choice
19. Which technique put emphasis on the
impact of the project on the net income rather
than the expected cash flows.

A. Net present value

B. Breakeven cash flow
C. Internal rate of return
D. Accoun0ng rate of return

59
 KC: Mul0ple Choice
20. Which capital budge0ng methods require
the use of the present value?
A. Net present value and 0me-adjusted rate of return
B. Payback and accoun0ng rate of return
C. Accoun0ng rate of return and 0me-adjusted rate of
return
D. Accoun0ng rate of return, 0me-adjusted rate of return,
net present value and payback.

60
 KC: Problem Solving
21. Grimaldi Company invested in an eight-year
project. It is expected that the annual cash
flow form the project, net of income taxes, will
be P82,500. Assuming that Amy based its
investment decision on an internal rate of
return of 13%, how much did the project cost?

61
 KC: Problem Solving
22. A planned factory expansion project has an
es0mated ini0al cost of P800,000. Using a
discount rate of 20%, the present value of future
cost savings from the expansion is P843,000. To
yield a 0me adjusted rate of return of 20% or
more, the actual investment cost cannot exceed
the P800,000 es0mate by more than _____.

62
 KC: Problem Solving
23. Silky Products is considering two pieces of
machinery. The first machine costs P50,000 more
than the second machine. During the two-year
life of these two alterna0ves, the first machine
has a P155,000 more cash flow in year one and a
P110,000 less cash flow in year two than the
second machine. All cash flows occur at year-end.

At what discount rate would Machine 1 be equally

acceptable as Machine 2?

63
 KC: Problem Solving
24. Jazz Insurance Company’s management is considering
an adver0sing program that would require an ini0al
expenditure of P291,280 and bring in addi0onal sales
over the next five years. The cost of adver0sing is
immediately recognized as expense. The projected
addi0onal sales revenue in Year 1 is P75,000, with
associated expenses of P25,000. The addi0onal sales
revenue and expenses from the adver0sing program
are projected to increase by 10% each year.
a.  Assuming a tax rate of 30%, the payback period for
the adver0sing program is ___.
b.  Compute for the payback reciprocal rate

64
 KC: Problem Solving
25. OMG Company has decided to invest in some new
equipment. The equipment will have a three-year life
and will produce a uniform series of cash savings. The
net present value of the equipment is P115,700, using
a discount rate of 8%. The internal rate of return is
12%.

a.  What is the amount of annual cash inflow?

b.  What is the accoun0ng rate of return using average
investment if the equipment will be depreciated using
straight-line method without salvage value?

65
 KC: Problem Solving
26. Swing Inc. is considering a project with the following cash flows.
Year Cash Flow
0 (P520,000)
1 P  255,000
2 P  160,000
3 P 347,000
4 (P  132,000)
5  P  289,500

If the company’s required rate of return is 10%, compute for the

project’s: a) discounted payback period, b) profitability index, c)
modified internal rate of return
 KC: Problem Solving
27. Epsilon, Inc. is considering a project with an ini0al
cash ouvlow of P300,000 that is expected to generate
aher-tax cash flows of P85,000 annually for the next
five years. Certainty equivalent coefficients these cash
flows are: Y1-0.90 Y2-0.85 Y3-0.80 Y4-0.75 and Y5-0.70

The normal required rate of return for the firm is 10%

while risk-free rate is 4.5%. Compute for:
a)  project’s risk-adjusted NPV using certainty equivalents
b)  project’s RADR using the risk-adjusted NPV computed
in (a)
67
 KC: Problem Solving
28. Games Unlimited Inc. is considering a new game that
would require an investment of P20 million. If the new
game is well received, then the project would produce
cash flows of P9.5 million a year for 3 years. However, if
the market does not like the new game, then the cash
flows would be only P6.0 million per year. There is a
50% probability of both good and bad market
condi0ons. The firm could delay the project for a year
while it conducts a test to determine if demand would
be strong or weak. The project's cost and expected
annual cash flows would be the same whether the
project is delayed or not. If the WACC is 9%, what is the
value of the investment 0ming op0on?

68