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**CFA Practice Question**

A venture capital project has the following estimated probabilities of failure over the next five years.

Year 1 2 3 4 5

Prob 10% 25% 30% 10% 10%

If it "survives", the payoff is expected to be $80 million. The initial investment required is $20 million. If the risk-adjusted discount rate is 20%, what is the project's expected NPV? (Round to the nearest $100,000)

Year 1 2 3 4 5

Prob 10% 25% 30% 10% 10%

If it "survives", the payoff is expected to be $80 million. The initial investment required is $20 million. If the risk-adjusted discount rate is 20%, what is the project's expected NPV? (Round to the nearest $100,000)

A. -$7.1 million.

B. -$7.7 million.

C. -$8.5 million.

**Explanation:**The probability of success equals the probability that the investment "survives" until the end of the fifth year:

Probability of success = 0.90 x 0.75 x 0.70 x 0.90 x 0.90 = 0.3827

Expected payoff = $80,000,000 x 0.3827 = $30,616,000

Discounted payoff = $30,616,000/(1.20)

^{5}= $12,303,884

NPV = $12,303,884 - $20,000,000 = -$7,696,116

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**User Contributed Comments**
5

User |
Comment |
---|---|

jgraham6 |
good question |

dini85 |
if probability of success is taken into consideration... why probability of failure is ignored... Can someone explain.. |

Skrills |
it's not that it's ignored, you use probablity of success to solve, and in question they gave you prob of failure to add extra work |

leftcoast |
But, doesn't -$20,000,000 have to be multiplied by the probability of failure? |

abellochs |
You pay 20 mnl regardless of the outcome so you don't need to adjust it. 80mln payoff depends on the success of the project. |