Question

ABC, Inc. is about to launch a new product. The firm can use either a proven technology or a new (experimental) method. The proven technology will produce a certain cash flow of $24M. In contrast, the cash flow from the new technology are uncertain. If the new technology works, it will produce a cash flow of $28M next year. If it is unsuccessful, it will produce a zero cash flow next year. The probability of success is 0.8 and is uncorrelated with the market return. Both methods require a $20M dollar investment today. There are no cash flows after next year. The risk-free rate is 10%.  

a) Explain why we should use the risk-free rate to discount the cash flows from the old technology. Explain why we should use the risk-free rate to discount the cash flows from the new technology.

b) What is the NPV of using the old technology? What is the NPV of using the new technology? Which technology should an all equity firm choose?

c) ABC Inc. has decided to raise $20M by issuing zero-coupon debt due next year. The bondholders believe ABC’s assertion that they will use the old technology. (You could also assume that the bondholders have never heard about the new technology). What should be the face value of this debt (i.e., how much ABC should promise to pay to debtholders next year)?

Answer 1

Answer a)

he discount rate is the loan fee used to decide the present estimation of future incomes in standard limited income examination. The markdown rate may likewise allude to the loan cost charged by business banks through its rebate window.

The discount rate concept dependent on the time estimation of cash. It just bodes well for an organization to continue with another task if its normal incomes are bigger than its normal expenses in present time ,it means give profit. The markdown rate makes it conceivable to appraise how a lot of the task's future incomes would be worth in the present. The higher the markdown rate, the littler the present venture should be to accomplish the income required for the task to succeed.

Answer b)

Old Technology
Year	0	1
Cash flow	-$2,00,00,000	$2,40,00,000
Discounted rate	10.00%
PV Vash flow	-$2,00,00,000	$2,18,18,182
NPV	$18,18,182	21818182-20000000
New Technology
Cash flow	$2,24,00,000	0.8*28000000+0.20*0
Year	0	1
Cash flow	-$2,00,00,000	$2,24,00,000
Discounted rate	10.00%
PV Vash flow	-$2,00,00,000	$2,03,63,636
NPV	$3,63,636	20363636-20000000

As NPV old technology > NPV new technology , company should adopt old technology.

Answer C) The face value of bond can be $1000 . If company has good track record of performance with zero default , the yield should be near to risk free rate 10%.