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 $10 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $7 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 $17 million at the end of Year 3. Martin's WACC is 10%.

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.

NPV= .5[-10+ (7/1.13)+(7/1.13^2)+(7/1.13^3)]+.5[-10+ (1/1.13)+(1/1.13^2)+(1/1.13^3)]

= $-.555389 million

B.

NPV= .5[-10+(7/1.13)+(-2/1.13^2)+(30/1.13^3)]+ .5[-10+ (1/1.13)+(1/1.13^2)+(1/1.13^3)]

= $ 3.891 million

C.value of the growth option

NPV with option-NPV without option= 3.891- -.555389= $4.4459 million

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