Use decision-tree analysis to calculate the NPV of the project with the investment timing option.
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Use decision-tree analysis to calculate the NPV of the project with the investment timing option.
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Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10%, and the risk-free rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand with associated future cash flows of $45 million per year. There is also a 40% chance of average demand with cash flows of only $15 million per year. What is the expected NPV?
d. Now suppoe this project has an investment timing option, since it can be displayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the scenarios will still last 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option’s value.
e. Use decision-tree analysis to calculate the NPV of the project with the investment timing option.
f. Use a financial option pricing model to estimate the value of the investment timing option.
g. Now suppose that the cost of the project is $75 million and the project cannot be delayed. However, if Tropical Sweets implements the project then the firm will have a growth option: the opportunity to replicate the original project at the end of its life. What is the total expected NPV of the two projects if both are implemented?
h. Tropical Sweets will replicate the original project only if demand is high. Using decision-tree analysis, estimate the value of the project with the growth option. i. Use a financial option model to estimate the value of the project with the growth option.
j. What happen to the value of the growth option if the variance of the project’s return is 14.2%? What if it is 50%? How might this explain the high valuations of many startup high-tech companies that have yet to show positive earnings?
