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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

GROWTH OPTION Martin Development Co. is deciding whether to proceed with Project X. The cost would be $9 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $6 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 $10 million at the end of Year 2. Project Y would then be sold to another company at a price of $20 million at the end of Year 3. Martin's WACC is 11%.

  1. a. If the company does not consider real options, what is Project Xʹs expected NPV?
  2. b. What is Xʹs expected NPV with the growth option?
  3. c. What is the value of the growth option?

a.

Summary Introduction

To Determine: The expected NPV of Project X.

Introduction: The net present value is also termed as the discounted cash flow approach is a mainstream capital budget method that considers the time value of cash. It utilizes net present value of the investment as the base to accept or reject a projected investment in projects like buying of new machine, buying of stock or inventory etc.

Explanation

Determine the net present value at $6 million cash flow

Using a excel spreadsheet, the net present value is determined as $5,662,288.29.

Excel Spreadsheet:

Excel Workings:

Therefore the net present value at $6 million cash flow is $5,662,288.29

Determine the net present value at $1 million cash flow

Using a excel spreadsheet, the net present value is determined as -$6,556,285.28.

Excel Spreadsheet:

Excel Workings:

Therefore the net present value at $1 million cash flow is -$6,556,285.28

Determine the expected NPV

ExpectedNPVProjectX=[

b.

Summary Introduction

To Determine: The expected NPV of Project X with the growth option.

c.

Summary Introduction

To Determine: The value of growth option.

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