Mistake in Schweser Alternative investments? investment, first, cross, reference, expected

clearlycanadian

Alternative Investments study section 18.... cross reference to cfa book reading #73

page 267 number 11.

An investor makes a $1 million investment in a venture capital project that has an expected payoff of $5 million at the end of 4 years. The cost of capital is 10%. If the conditional annual failure probabilities over the first 4 years are 10%, 15%, 20%, and 15%, the expected NPV of the project is closest to:

a. $366, 067
b. $775, 834
c. $698, 057

I get $1,300,821.92. The answer is b.

BTW, is there a place where Schweser posts the errata?

There's an example to a similar question to this one on page 254-255.



Edited 2 time(s). Last edit at Saturday, April 3, 2010 at 10:27PM by homie.

ajpheif16

ans is b.

-1 Mill investment

5/1.1^4 -> payoff from the project. But this is only in the case project succeeds.

Probability of success of project = 0.9*.85*.8*.85=0.5202

So NPV=0.5202*5/1.1^4 - 1 = 0.776518...

closest to b.

CP

manasib

But there's a 48% chance of fail.

So NPV= (0.5202*5/1.1^4) - (0.48*1) = 1.3

thisisbrianly

irrespective of whether you fail or succeed - you invest the 1 Million.

2 ways of looking at this.

NPV on success ->
0.5202 * [5/1.1^4 - 1]

NPV on Failure:
0.4898 * [0 - 1] <-- 0 payoff, 1 invested.

sum of the two above.

= 0.5202 * 5/1.1^4 -1 [0.5202+0.4898] ==> same as -1*1

or the way I have done it above... which is equivalent. You invest the 1 Mill. regardless of success or failure.

CP

JRossSter

ans is b

NPV if poject is success:
-1 mn + (5/1.1^4) = 2,412,882

(Homie, you are missing '-1' mn here. We should consider outflow of 1 mn. Another way to look at it is that if you ignore discounting calculation , then total NPV if project succeed is 5-1= 4 mn and not 5 mn. hope it helps)


NPV is project fails :
- 1 Mn

Total NPV= (2412882*52.02%)- (479800*1) = 775,381 (appx ans is b)

dcfox83

i asked the same question not so long ago, everyone tells me its minus one million, so why does the example on page 255 on the note actually use probability weigthed average , but here doesnt.


had a closer look, now i get it.

example on page p255, the investment has not been made. question on p267, 1 million has already been paid.

soddy1979

lzen5 Wrote:
-------------------------------------------------------
> i asked the same question not so long ago,
> everyone tells me its minus one million, so why
> does the example on page 255 on the note actually
> use probability weigthed average , but here
> doesnt.
>
>
> had a closer look, now i get it.
>
> example on page p255, the investment has not been
> made. question on p267, 1 million has already been
> paid.


But if the investor from page p255 goes ahead to analyze the NPV, they would have to assume the full investment is going to be made and not the weighted average.

So b makes sense to me, but not the answer on p 255.

In other words, analyzing the investment should be the same whether you pay first and then analyze or analyze and then pay. If I'm going to value a company that is worth $50 that costs $20 it doesn't matter if I pay first and then analyze or analyze and then pay....

.... to take this one step further, you would never pay first and then analyze the NPV.