Probability calculation in NPV

Question

If the client is bidding on a contract and 100% likely to win, the NPV is (operating profit of 9M/discount rate of 10% - upfront cost of 50M) = 40M..in the next question they ask what is your NPV if you now have a 50% chance of winning. They calculate this as 50% of 9M/discount rate of 10%, which is 45M..why are they applying the probability to the first half of the equation? Can someone explain this?

Answer 1

Hi there,

I guess you mean that the expected operating profit, not the NPV, is $45M (without considering the upfront cost).

If they are applying the 50% just to the operating profits, it means that the upfront cost is incurred whether or not you win the bid, so it doesn’t depend on that.

Hope this helps,

Francesco

Answer 2

Hi there,

It literally depends on whether the upfront cost of 50M is incurred no matter what or based on acceptance of the contract.

If, no matter what, we get a op profit of 9M and a cost of 50M, then probability of 10% of 100% shouldn't change anything.

If op profit only occurs with a winning bid, we have to take the EV of that.

If upfront costs only occur with a winning big, we have to take the EV.

It sounds like the company has to make a $50M investment just to research the product etc...therefore, that cost is incurred no matter what, and you can't apply the 50% chance of winning to it!