Hybrid Memory, Inc., a firm that manufactures portable computer memory, is consi

Question

Hybrid Memory, Inc., a firm that manufactures portable computer memory, is considering building a facility to manufacture a new line of memory sticks. The firm estimates that the present value of cash flows from the new product line is $125 million and the present value of the investment expenditures is $100 million. Thus, the static NPV is $25 million. Management knows that there is a lot of uncertainty about the cash flows generated from the new product line, so they plan to operate the project for one year and then make adjustments to production in light of new information. Hybrid Memory estimates that the abandonment value of the facility producing the new product line is $75 million. They can also adjust production upwards or downwards. An expansion would cost $27 million and would increase the value of cash flows by 20%. They can reduce production, in which case they can generate a cash flow of 45 million by selling off some production capacity. The reduction in production would decrease the value of cash flows by 50%. Assume that all options are only available in the very last period (at T = 1). Make the following model assumptions: The expected volatility of cash flows is 50% per year; management observes information about expected cash flows every three months (At = A); the risk-free rate is 4.98%. What is the value of flexibility for the new product line investment?

Explanation / Answer

1.20(75)-27= 63   

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