Corporate Finance – Slot 5 - Quiz 2 Date: February 11, 2011 Maximum Time: 30 minutes

Instruction: Show detailed work to obtain proper credit

In January 2007, Boeing was contemplating the development of a small unmanned aerial vehicle (UAV)
that had a number of possible applications, including monitoring of electrical transmission lines, pipeline
safety, forest health and border security.

But the UAV development critically depended on advances in technologies related to aviation control
systems, remote sensing and global positioning. Hence, the immediate outlay for the UAV project was
$15 million for R&D to achieve engineering breakthroughs in the key technologies. The R&D project was
expected to take up to two years. They were willing to abandon the project if the R&D outcome failed to
deliver the critical break-through required to develop a superior product.

Contingent on the success of the R&D efforts at the end of two years, Boeing was expected to spend $325
million to launch the product. This one-time outlay was required for the UAV design, testing and
manufacturing facility building.

Boeing was not alone in the race for the new UAV, in fact, all the major aircraft manufactures were
believed to be developing similar UAVs. The estimates of post-tax operating cash flows net of working
capital investments, from sales of UAVs under different product-market scenarios based on the
information available in January 2007were as follows. The fixed assets would be fully depreciated and no
salvage value was expected at the end of the project:

Year 1 2 3 4 5 6 7 8 9
Optimistic 0 0 80 116 153 177 223 268 314
Most Likely 0 0 52 62 74 77 89 104 122
Pessimistic 0 0 20 23 24 18 20 20 22

Description of the scenarios:

Optimistic (10% probability) : Superior product, sales growth 25% per annum.

Most likely (80% probability) : Average product, moderate competition, sales growth approximately
about 15% per annum.

Pessimistic (10% probability) : Average product, but severe competition limits sales growth to about 5%
per annum.

The operating cash flows and investments were subject to risk and the appropriate discounting rate was
considered to be 15%. Boeing’s management recognized that by the time the R&D outcome is known, it
would have significant clarity about the demand scenario that would follow for its UAVs (from among
the three projected scenarios). Boeing had already spent $1 million for market research on the product.

Questions:

1. What is the expected NPV of the UAV project based on information available to Boeing as of
January 2007, assuming no abandonment? Should Boeing undertake the launch of the UAV by
investing $325m based on this analysis? -$7.41

2. Given the willingness to abandon the UAV project at the end of two years, estimate the NPV of
the project as of January 2007. Should Boeing undertake the development of the UAV based on
the estimate? $13.85 YES

3. What is the worst case loss for Boeing from the UAV project with abandonment? -$15

4. Estimate the incremental value created by the flexibility to abandon the UAV project at the end of
two years, compared to the development and launch of UAV as a commitment (give your
calculations).