Martin Development Co. is deciding whether to proceed with Project X. The cost w

Question

Martin Development Co. is deciding whether to proceed with Project X. The cost would be $8 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $5 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, that would require $9 million outlay at the end of Year 2. Project Y would then be sold to another company at a price of $19 million at the end of Year 3. Martin's WACC is 13%.

a. If the company does not consider real options, what is Project X's NPV? Round your answer to two decimal places. If the answer is negative, use minus sign.
$   million

b. What is X's NPV considering the growth option? Round your answer to two decimal places. If the answer is negative, use minus sign.
$   million

c. What is the value of the growth option? Round your answer to two decimal places. If the answer is negative, use minus sign.
$   million

Explanation / Answer

a)

Project X NPVbest case = -8+(5/1.13^1)+(5/1.13^2)+(5/1.13^3) = $3.80576

Project X NPV worst case = -8+(1/1.13^1)+(1/1.13^2)+(1/1.13^3) = -$5.638847

Project X NPV (expected value) = .5*3.80576-.5*5.638847 = -$0.9165435 million = -$0.92 million

b)

if X considered growth option

for best case

cash flow for year 0 = -8 million

cash flow for year 1 = 5 million

cash flow for year 2 = 5-9 = -$4million

cash flow for year 3 = 19+5 = $24 million

NPV (best case) = -8+(5/1.13^1)-(4/1.13^2)+(24/1.13^3) = $9.925395

NPV worst will be same as before = -5.638847

Project NPV (considereng real options) = .5*9.925395-.5*5.638847 = $2.143274 = $2.14

c)

value of growth option = 2.143274-(-0.9165435) = $3.0598 = $3.06

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