The company WHY is evaluating the possibility of building a warehouse (the project'). It implies an immediate investment cost (year zero) of €350 million. The discounted value (year zero) of expected cash flows is €275 million. However, WHY has the option to further invest €125 million within 1 year, which will enable it to triplicate the warehouse capacity, increasing by 60% the discounted value of cash flows. Assume the following: • Risk free interest rate: 2% per year. • The project gross value follows a multiplicative binomial process. • Method for the computation of remaining relevant inputs: compound annual growth. The market value of the shadow asset is given by S. Currently S = 18 and the estimation is that within 1 year S = 29 and S = 12 for the scenarios of favourable and unfavourable market evolution, respectively. In your answers to the next questions make plausible assumptions if necessary. In case you prefer, standard characters can be used (e.g b rather than B, capital_sigma rather than E). Round computations to two decimal places (e.g., 1.555 is rounded to 1.56). a. What is the real option in this project? Explain your answer. b. What is the value of the investment opportunity (expanded NPV) that the project represents? Explain your answer. c. What should be the investment decision regarding this project? Explain your answer. d. Consider the following statement: "Real options techniques provide an important contribution for the valuation exercise of a project that is developed with a lot of flexibility regarding its implementation". Do you agree with this statement? Explain your answer.
The company WHY is evaluating the possibility of building a warehouse (the project'). It implies an immediate investment cost (year zero) of €350 million. The discounted value (year zero) of expected cash flows is €275 million. However, WHY has the option to further invest €125 million within 1 year, which will enable it to triplicate the warehouse capacity, increasing by 60% the discounted value of cash flows. Assume the following: • Risk free interest rate: 2% per year. • The project gross value follows a multiplicative binomial process. • Method for the computation of remaining relevant inputs: compound annual growth. The market value of the shadow asset is given by S. Currently S = 18 and the estimation is that within 1 year S = 29 and S = 12 for the scenarios of favourable and unfavourable market evolution, respectively. In your answers to the next questions make plausible assumptions if necessary. In case you prefer, standard characters can be used (e.g b rather than B, capital_sigma rather than E). Round computations to two decimal places (e.g., 1.555 is rounded to 1.56). a. What is the real option in this project? Explain your answer. b. What is the value of the investment opportunity (expanded NPV) that the project represents? Explain your answer. c. What should be the investment decision regarding this project? Explain your answer. d. Consider the following statement: "Real options techniques provide an important contribution for the valuation exercise of a project that is developed with a lot of flexibility regarding its implementation". Do you agree with this statement? Explain your answer.
Intermediate Financial Management (MindTap Course List)
13th Edition
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Eugene F. Brigham, Phillip R. Daves
Chapter12: Capital Budgeting: Decision Criteria
Section: Chapter Questions
Problem 16P: Shao Airlines is considering the purchase of two alternative planes. Plane A has an expected life of...
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Transcribed Image Text:The company WHY is evaluating the possibility of building a warehouse (the project'). It
implies an immediate investment cost (year zero) of €350 million. The discounted value
(year zero) of expected cash flows is €275 million. However, WHY has the option to further
invest €125 million within 1 year, which will enable it to triplicate the warehouse capacity,
increasing by 60% the discounted value of cash flows.
Assume the following:
• Risk free interest rate: 2% per year.
• The project gross value follows a multiplicative binomial process.
• Method for the computation of remaining relevant inputs: compound annual
growth. The market value of the shadow asset is given by S. Currently S =
18 and the estimation is that within 1 year S = 29 and S = 12 for the
scenarios of favourable and unfavourable market evolution, respectively.
In your answers to the next questions make plausible assumptions if necessary. In case
you prefer, standard characters can be used (e.g b rather than B, capital_sigma rather
than E). Round computations to two decimal places (e.g., 1.555 is rounded to 1.56).
a. What is the real option in this project? Explain your answer.
b. What is the value of the investment opportunity (expanded NPV) that the project
represents? Explain your answer.
c. What should be the investment decision regarding this project? Explain your
answer.
d. Consider the following statement: "Real options techniques provide an important
contribution for the valuation exercise of a project that is developed with a lot of
flexibility regarding its implementation". Do you agree with this statement? Explain
your answer.
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