Advanced Corporate Finance Problem Set

Problem Set VI

1. The management of ABC company is considering the development of a high-tech project (a “pioneer venture”). This project involves a high initial costs and insufficient projected cash inflows. The cash flows from the project are as follows. Investment outlay I0=$500 million; cash inflows over 4 years: C1 = $100 million, C2 = $200 million, C3= $300 million, and C4 = $100 million (see figure 1). If the technology is proven during the initial 4 years, at year 4, the project could be expanded into a commercial project which is three times the pioneer venture (i.e., I4 = 1.5 billion, with 3 times the cash inflows in subsequent years as represented in figure 1). However, there is an uncertainty associated with the cash flow projections, represented by a standard deviation σ = 0.35. The opportunity cost of capital for the pioneer venture is 20%.  The risk free rate r = 10%. Should the management invest in this pioneer venture?

                  100          200              300         100         300            600                 900          300

      500                                        1500

Figure 1

1. Assume that a pharmaceutical firm has the patent rights, for the next 20 years, to a drug that requires an initial investment of $1.5 billion to develop and a present value, right now, of cash inflows of only $1 billion. The drug is very expensive to produce now, but the technology is rapidly evolving, and there is a possibility that this project will become valuable in the future. Assume that a simulation of the project under a variety of technological and competitive scenarios yields a variance in the present value of inflows of 0.03. The current risk-free 20-year bond rate is 10%. The cost of delaying the investment, for each year of delay, is 1/20: i.e, 5% per year.  (i) What is the NPV of developing eh drug now? (ii) What is the value of the patent on this drug?

1. At the beginning of 1996, Anheuser-Busch (BUD) was considering whether to invest $4 million in return for a 4.4% stake of Companhia Cervecerias Unidas (CCU) in Argentina. This joint venture would allow BUD to “test the waters” and see whether or not the Chilean/Argentine market is worth a multibillion-dollar capital investment. According to the joint venture agreement, if BUD decides to make the required investment to expand operations in Argentina, BUD would be given an expanded equity stake in CCU of 20% by the end of 2002;  the two companies would then together expand operations in Argentina. Initial facilities would take one year to build, and distribution of the product would begin at that time. Production would grow quickly through 2005 as more facilities would be added; the complete strategy would take until 2013 to complete, and the estimated 2002 nominal present value of the entire fixed capital commitment would be $2.5 billion. Refer to table 1 for the projected operating cash flows for BUD. The volatility of the projection is 35% per year. The risk free rate per year is 7%. The cost of capital for BUD is 9.9%. (i) Assume first that BUD has to commit in 1996 itself to implement the expanded investment in 2002. What is the present value to BUD of investing in the joint venture in this case? (2) Assume now that there is no such current commitment, and BUD has till the end of 2002 to make a decision regarding whether or not to make the required investment to expand operations. Should BUD enter the joint venture today (1996)?

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