You ate considering introducing a new Tex-Mex-That fusion restaurant The initial

Question

You ate considering introducing a new Tex-Mex-That fusion restaurant The initial outlay on this new restaurant is $6 6 million and the present value of the free cash flows (excluding the initial outlay) is S' J million, such that the project has a negative expected NPV of SI 3 million. Upon closer examination. you find that there is a 60 percent chance that this new restaurant will be well received and will produce annual cash flows of $814,000 per year forever (a perpetuity), while there is a 40 percent chance of it producing a cash flow of only $210,000 per year forever (a perpetuity) if it isn't received well. The required rate of return you use to discount the project cash flows is 10 9 percent. However, if the new restaurant is successful, you will aide to build 12 more of them and they will base costs and cash flows similar to the successful restaurant's costs and cash flows In spite of the fact that the first restaurant has a negative NPV. should you build it anyway? Why or why not? What is the expected NPV for this project if only one restaurant is built but isn't well received? What is the expected NPV for this project assuming 12 more are built if the first restaurant is well received? (Ignore the fact that that would be a time delay m building additional new restaurants )

Explanation / Answer

Ans 1 Though the NPV is negative , company can build the restaurant because the company can excersice the real option . Value of the real option is 537,68,807.34 Scenario Perpetuity Cash Flow Probablity Rate of return Present Value Present Value * probablity Successful                                                                 8,14,000.00 0.6 10.90%     74,67,889.91 44,80,733.94 Failure                                                                 2,10,000.00 0.4 10.90%     19,26,605.50     7,70,642.20 52,51,376.15 Present value of cash flow if successful for one project    74,67,889.91 Present value of cash flow if successful for additional 12 projects 896,14,678.90 Real Value option=Present value of cash flow if successful for additional 12 projects* Proboablity of success 537,68,807.34 Ans 2 (a) Failure Initial Cash outlay -53,00,000.00 Present value of cash inflows    19,26,605.50 NPV -33,73,394.50 Ans 2 (b) Cash flow stream Amount Probablity Expected Value Present value of cash flow if successful for one project    74,67,889.91 Present value of cash flow if successful for additional 12 projects 896,14,678.90 Total 970,82,568.81 0.6 582,49,541.28 Present Value of cash inflow if not successful    19,26,605.50 0.4       7,70,642.20 590,20,183.49 Initial Outlay -53,00,000.00 NPV 537,20,183.49

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