Samsung Electronics is considering production of a new cell phone. The project w

Question

Samsung Electronics is considering production of a new cell phone. The project will require an investment of $20 million and generate $8 million per year over the next 3 years. If the phone is well-received (good condition), the project will produce cash flows of $9 million a year for 3 years; but if the market does not like the product (bad condition), the cash flows will be only $5 million per year. There is a 50% probability of both good and bad market conditions. Samsung can delay the project two years while it conducts a test to determine whether demand will be strong or weak. The delay will not affect the projects required investment or its cash flows. Samsungs WACC is 6%.

a) What kind of real option does Samsung consider?

b) What action do you recommend? Take it immediately or wait? Show all your work.

Explanation / Answer

Base/Real case Good Market conditions--Inc*).50 Bad Market conditions-Inc*0.50 Year Details Outflow/inflow WACC F @ 6% PV Outflow/inflow WACC F @ 6% PV Outflow/inflow WACC F @ 6% PV 0 Initial Inv -20000000 1 -20000000 -20000000 1 -20000000 -20000000 1 -20000000 1 Annual Income 8000000 0.9434 7547200 4500000 0.9434 4245300 2500000 0.9434 2358500 2 8000000 0.89 7120000 4500000 0.89 4005000 2500000 0.89 2225000 3 8000000 0.83962 6716960 4500000 0.83962 3778290 2500000 0.83962 2099050 NPV 1384160 -7971410 -13317450 Base/Real case Good Market conditions--Inc*).50 Bad Market conditions-Inc*0.50 Year Details Outflow/inflow WACC F @ 6% PV Outflow/inflow WACC F @ 6% PV Outflow/inflow WACC F @ 6% PV 1 2 Initial Inv@beg. Of 3rd yr -20000000 0.89 -17800000 -20000000 0.89 -17800000 -20000000 0.89 -17800000 3 Annual Income 8000000 0.83962 6716960 4500000 0.83962 3778290 2500000 0.83962 2099050 4 8000000 0.79209 6336720 4500000 0.79209 3564405 2500000 0.79209 1980225 5 8000000 0.74726 5978080 4500000 0.74726 3362670 2500000 0.74726 1868150 NPV 1231760 -7094635 -11852575 b) Considering all the NPVs taking it immediately and also real case or base case is recommended-- as that gives maximum NPV

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