Question Three CC ltd has developed a scientifically more effective Ebola drug than the ones

currently in the market. One option before the company is to start production on a large scale by
installing a large plant costing $50. Alternatively, it can start by installing a small plant at a cash
outlay of $10 and then decide to expand the capacity after a year at a cost of $45 if the initial
demand is high. There is a 50-50 chance that demand will be high or low. If it is high then there
is a 70% chance that demand in the subsequent years will be high. If it turns out to be low, it is
expected to be low in subsequent years also. The larger plant is likely to generate net cash flows
of $10 in year 1 if demand is high and $7 if demand is low. With a high initial demand, cash
flows are expected to be $16 in perpetuity if the subsequent demand is also high and $10 if the
subsequent demand is low. The subsequent demand will remain low if the initial demand is low
and the expected cash flow in perpetuity is $7. The small plant is expected to yield a net cash
flow of $4 in year 1 if demand is high and $2 if demand is low. If the initial demand is high, the
company will expand its capacity and it is expected to generate net cash flows $20 in perpetuity
if the subsequent demand was is high and $8 if the subsequent demand is low. If the initial
demand is low, the subsequent demand will be low and expected net cash flow is $2 in
perpetuity. Assuming CC has a 20% cost of capital, what should CC ltd do? (14 marks)

Solution

Option 1 (installing a large plant at $50)

$10 0.7 $16

$50 0.5 0.3 $10

0.5

$7

The present value of cash flow

Year 1 Expected cash flows: 0.5(10) + 0.5(7)

=$5 +$3.5

=$8.5
Year 2 Expected cash flows: 0.7(16) +0.3(10)

=$11.2 + $3

=$14.2 perpetuity

Present value of expected cash flows

Year 1: $8.5 × (1/(1+0.2)1 )

=$7.08

Year 2: perpetuity $14.02/0.2

=$71

Present value Year 0: $71/1.2

=$59.17

Total expected cash flows: $59.17 + $7.08

=$66.25

Expected Net Present Value: $66.25 - $50

=$16.25

Option 2 (small plant first then expand)

Year 1 $4 Year 2 $20

$10 0.5 $45 0.7

0.5 $2 0.3 $8
Expected cashlows

Year 1: 0.5($4) + 0.5($2) Year 2: 0.7($20) + 0.3($8)

= $2 + $1 =$14 +$2.4

=$3 =$16.4 (perpetuity)

Expected Present Value of cash flows

Year 1: $3 × (1/(1+1.02)1) Year 2: $16.4/0.2

=$2.5 =$82

Present value at Year 0: $82/1.2

=$68.33

Total present value of cash flows

$68.33 + $2.5

=$70.83

Present value of investments

Year 1 =$10

Year 2 = $45/1.2

=$37.5

Net present value = $70.83 + $47.5

=$23.33

From the above calculation CC should consider using option 2 whereby it starts by installing a
small plant. The net present value of option 1 is $16.25 and that of option 2 is $23.33 which
signifies that option 2 is favorable. Also the total expected cash flow of option 2 is $70.83 which
is attractive as compared to $66.25 from option 1.