Martin Development Co. is deciding whether to proceed with Project X. The cost would be $11 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $7 million per year during Years 1, 2, and 3. However, there is a 50% chance that X would be less successful and would generate only $1 million per year for the 3 years. If Project X is hugely successful, it would open the door to another investment, Project Y, which would require an outlay of $13 million at the end of Year 2. Project Y would then be sold to another company at a price of $26 million at the end of Year 3. Martinâs WACC is 14%.
a)If the company does not consider real options, what is Project Xâs expected NPV?
b)What is Xâs expected NPV with the growth option?
c)What is the value of the growth option?
Martin Development Co. is deciding whether to proceed with Project X. The cost would be $11 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $7 million per year during Years 1, 2, and 3. However, there is a 50% chance that X would be less successful and would generate only $1 million per year for the 3 years. If Project X is hugely successful, it would open the door to another investment, Project Y, which would require an outlay of $13 million at the end of Year 2. Project Y would then be sold to another company at a price of $26 million at the end of Year 3. Martinâs WACC is 14%.
a)If the company does not consider real options, what is Project Xâs expected NPV?
b)What is Xâs expected NPV with the growth option?
c)What is the value of the growth option?
Related questions
The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $6 million today. Bush estimates that once drilled, the oil will generate positive cash flows of $4 million a year at the end of each of the next 4 years. Although the company is fairly confident about its cash flow forecast, it recognizes that if it waits 2 years, it will have more information about the local geology as well as the price of oil. Bush estimates that if it waits 2 years, the project will cost $8 million, and cash flows will continue for 4 years after the initial investment is made. Moreover, if it waits 2 years, there is a 70% chance that the cash flows will be $4.3 million a year for 4 years, and there is a 30% chance that the cash flows will be $2.2 million a year for 4 years. Assume that all cash flows are discounted at 9%.
If the company chooses to drill today, what is the projectâs expected net present value?
Expected NPV = million (to 4 decimals)
Would it make sense to wait 2 years before deciding whether to drill? Explain.
| NPV of waiting | million (to 4 decimals) |
(yes or no), because the NPV of waiting two years is (less or greater) than going ahead and proceeding with the project today.
What is the value of the investment timing option?
$ million (to 4 decimals)
What disadvantages might arise from delaying a project such as this drilling project?
