Consider the following: A factory can produce 150,000 units of a good/year at a cost of $100/unit may produce the good for 2 years Retail price is initially $500/unit, but will either increase or decrease by $100 during year 1, and then subsequently increase or decrease by $200 during year 2. Each year, the increase or decrease is equally likely Fixed costs of running the factory are $50M per year if the factory is implemented (not including rent) Rent is $10M, whether or not the factory is set-up We will assume risk neutrality and a 10% cost of capital For simplicity, we will assume that there is no initial (year 0) cashflow associated with the factory The production technology of the factory allows for flexible starting (but not stopping). This means that in year 1, the factory may be operated or not. If the factory is operational in year 1, it will also be operational in year 2. If the factory is not operational in year 1, then it may either be operated or not in year 2. What is the present value of the factory with this technology? The production technology of the factory allows for flexible stopping (but not starting). This means that the plant may be shut down at any point. However, once the plant is shut down, then it will remain out of operation for the remainder of the life of the project. What is the present value of the factory with this technology?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter10: Capital Budgeting: Decision Criteria And Real Option

Section10.A: Mutually Exclusive Investments Having Unequal Lives

Problem 2P

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Consider the following:
- A factory can produce 150,000 units of a good/year at a cost of $100/unit may produce the good for 2 years
- Retail price is initially $500/unit, but will either increase or decrease by $100 during year 1, and then subsequently increase or decrease by $200 during year 2. Each year, the increase or decrease is equally likely
- Fixed costs of running the factory are $50M per year if the factory is implemented (not including rent)
- Rent is $10M, whether or not the factory is set-up
- We will assume risk neutrality and a 10% cost of capital
- For simplicity, we will assume that there is no initial (year 0) cashflow associated with the factory
  1. The production technology of the factory allows for flexible starting (but not stopping). This means that in year 1, the factory may be operated or not. If the factory is operational in year 1, it will also be operational in year 2. If the factory is not operational in year 1, then it may either be operated or not in year 2. What is the present value of the factory with this technology?
  2. The production technology of the factory allows for flexible stopping (but not starting). This means that the plant may be shut down at any point. However, once the plant is shut down, then it will remain out of operation for the remainder of the life of the project. What is the present value of the factory with this technology?

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