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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

GROWTH OPTION Singh 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 $8 million at the end of Year 2. Project Y would then be sold to another company at a price of $16 million at the end of Year 3. Singh’s WACC is 9%.

  1. a. If the company does not consider real options, what is Project X’s expected NPV?
  2. b. What Is X’s 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 when the company does not consider real options.

Introduction:

NPV is the variation between the present value of the cash outflows and the present value of the cash inflows. In capital budgeting, the NPV is utilized to analyze the profitability of a project or investment.

Explanation

Given information:

S Company is deciding whether to continue with the Project X which cost $11,000,000 (initial investment). There is 50% probability that Project X will be successful and it would be able to generate annual after-tax cash flows of $7,000,000 per year. Even there is 50% chance that the Project X will not be successful and could make only $1,000,000 per year for 3 years.

In case, the Project X is successful then the company can enter into another Project that is Project Y. this Project Y needs an outlay of $8,000,000 at the end of Year 2. It will be sold to another company for $16,000,000 in the end of Year 3 and the WACC is 9 percent.

Compute the NPV when the Project X is successful:

The table below shows the Excel formula to calculate the NPV:

The table below shows the calculated values of the NPV:

Hence, the NPV when the Project X is successful is $6,719,063.

Compute the NPV when the Project X is not successful:

The table below shows the Excel formula to calculate the NPV:

The table below shows the calculated values of the NPV:

Hence, the NPV when the Project X is not successful is −$8,468,705...

b.

Summary Introduction

To determine: The expected NPV of Project X with growth options.

Introduction:

Growth option is a type of real options. It exists when the investment creates an opportunity to make profitable investments. It takes place when a company starts a project in a new market or new country. This can add value to projects from its cash flows. It also provides other opportunities for the company in the new market or country.

c.

Summary Introduction

To determine: The value of growth options.

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