Solved:Can anyone pls solve this

CFA Level I
#1

Bouchard Industries is a Canadian company that manufactures gutters for residential houses. Its management believes it has developed a new process that produces a superior product. The company must make an initial investment of CAD190 million to begin production. If demand is high, cash flows are expected to be CAD40 million per year. If demand is low, cash flows will be only CAD20 million per year. Management believes there is an equal chance that demand will be high or low. The investment, which has an investment horizon of ten years, also gives the company a production-flexibility option allowing the company to add shifts at the end of the first year if demand turns out to be high. If the company exercises this option, net cash flows would increase by an additional CAD5 million in Years 2–10. Bouchard’s opportunity cost of funds is 10%.

The internal auditor for Bouchard Industries has made two suggestions for improving capital allocation processes at the company. The internal auditor’s suggestions are as follows:

Suggestion 1: “In order to treat all capital allocation proposals in a fair manner, the investments should all use the risk-free rate for the required rate of return.”

Suggestion 2: “When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR.”

Question

What is the NPV (CAD millions) of the optimal set of investment decisions for Bouchard Industries including the production-flexibility option?

  1. –CAD6.34 million
  2. CAD7.43 million
  3. CAD31.03 million

acording to the problem the npv of the 5mm option is NPV=∑10t=251.10t=C$26.18 million.
but i’m still getting npv = 27.92 , can anyone help me solve this problem?

#2

well in the end i solved it , dont really know how the book did it , but here is how i did it:

  1. Calculate the expected cash flows for each scenario:
  • High demand scenario: Cash flows are CAD40 million per year for 10 years, plus an additional CAD5 million in years 2-10 if the production-flexibility option is exercised. So, the cash flows for this scenario are:

CF0 = -190 CF1 = 40 CF2 = 45 CF3 = 45 CF4 = 45 CF5 = 45 CF6 = 45 CF7 = 45 CF8 = 45 CF9 = 45 CF10 = 45

  • Low demand scenario: Cash flows are CAD20 million per year for 10 years, with no production-flexibility option. So, the cash flows for this scenario are:

CF0 = -190 CF1 = 20 CF2 = 20 CF3 = 20 CF4 = 20 CF5 = 20 CF6 = 20 CF7 = 20 CF8 = 20 CF9 = 20 CF10 = 20

after that just NPV 10.5 +NPV 20.5
so then u get the answer (b) CAD7.43 million.
i still got no clue on how the book got the 26.18.

#3

The extra $5 million doesn’t start until the end of the second year:

CF0 =0 C01=0 F01=1 C02=5 F02=9
2ND QUIT
NPV worksheet
I=10 CPT NPV 26.17738

1 Like
#4

Waaaaay too many keystrokes!!!

CF0 -190 C01 30 F01 1 C02 32.5 F02 9
NPV worksheet
I 10 CPT NPV 7.4257 :+1:

1 Like
#5

XD :V thankss

#6

Hi - sorry how did you get 32.5 for C02.? thank you!!

#7

32.5 = (1/2) * 20 + (1/2)*(40+5)

Average of the low and high situations. :nerd_face:

#8

Ah - got it. Thanks so much