CFA Practice Question

There are 139 practice questions for this study session.

CFA Practice Question

A venture capital investment is expected to yield of payoff of $100 million in five years if it survives. The initial cost is $20 million and the appropriate discount rate is 20%. What is the average annual probability of failure that makes the investment's NPV = 0? In other words, what is the maximum annual average probability of failure before the investment is not acceptable?
A. 13%
B. 17%
C. 20%
Explanation: The NPV is equal to zero when:
Discounted expected payoff = Initial cost
[(1 - Average prob)5 $100 million] / (1.20)5 = $20 million
Average annual probability = 0.1303, or 13%

User Contributed Comments 8

User Comment
chamad More details? Anyone? with BAII if possible? Thanks
chamad Ok Got it. Discounted expected payoff = PAY OFF * prob of succes each year (p1*p2*p3*p4*p5). Since we are considering an average=p5.
Remember we're looking for prob of failure and not success so use (1-p)5
azramirza Solve for opp
maria15 Can someone please explain? Thanks
bluejazzy1 NPV = 0 when initial cost = pv of cf

for the project to happen, it must not fail in 5 years, therefore it faces a probability of surviving (we can call that X) every year. The probability of it surviving 5 years would be x^5.

The probability of it not surviving 5 years is (1-X)^5
mynotes1 This answer ignores the impact to NPV under the 'Failure' scenario. The NPV is the weighted ave of the 'success' and 'failure' scenarios. in this case, prob fail = 50.15% that the 20M outlay is lost, so total NPV actually = -10.03M
ebola bluejazzy1 - you got it backwards. It's asking for prob of failure. 1-prob failure = success. Therefore, the threshold of failure is prob of failure and you set the two equal to know the limit of success. 1-x in this case is prob of success.
Chl4072 How to calculate by BA II...?thanks. no understand
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