Concept explainers
Your firm is thinking of expanding. If you invest today, the expansion will generate $10 million in FCF at the end of the year, and will have a continuation value of either $150 million (if the economy improves) or $50 million (if the economy does not improve). If you wait until next year to invest, you will lose the opportunity to make $10 million in FCF, but you will know the continuation value of the investment in the following year (that is, in a year from now, you will know what the investment continuation value will be in the following year). Suppose the risk-free rate is 5%, and the risk-neutral probability that the economy improves is 45%. Assume the cost of expanding is the same this year or next year.
- a. If the cost of expanding is $80 million, should you do so today or wait until next year to decide?
- b. At what cost of expanding would there be no difference between expanding now and waiting? To what profitability index does this correspond?
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Corporate Finance: The Core (4th Edition) (Berk, DeMarzo & Harford, The Corporate Finance Series)
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