Finance Question Continuation: Answer letter e ONLY! (FYI for Fincharge Tutor) (

Question

Finance Question Continuation: Answer letter e ONLY! (FYI for Fincharge Tutor)

(You are given with the following information of two projects planned by your company. Each cash flow per year shown in Table 1 represents the cash flow at the end of each year during the project. For instance, for project A, the cash flow as 735 in first year is expected at the end of the Year 1. The initial outlays for the projects are paid out by installments with regular payments as 0.74 million at the beginning of each year for project 1 and $0.81 million per beginning of each year for project 2, respectively.

e) Suppose there is a 40% chance that the market may be bad and the cash flows for both projects when market condition is bad will change to

That is to say, the original cash flows in Table 1 only have 60% chance to happen. What is your decision for each project? What is the value contributed by the “Real Option”(that is, the possibility to discontinue the project) for each project if you can discontinue the projects when you find out that they may not be successful when possible negative cash flows are expected?

Thank you in advance!

Explanation / Answer

I am assuming the cost of capital to be 14%

Initial Investment for A can be calulated using the PV fuction of excel. The syntax for the same is: =PV(14%,5,740,0,1).

The value comes out to be $2986.15

Thus, for project A,

When the market is bad

Expected NPV = 60% * 2713.57 - 40% * 3988.05 = $32.92

Initial Investment for B can be calulated using the PV fuction of excel. The syntax for the same is: =PV(14%,3,810,0,1).

The value comes out to be $2143.80

Thus, for project B,

When the Market is bad,

Expected NPV = 60% * 2113.19 - 40% * 3934.78 = -$306

SInce expected NPV of project A is positive, we will accept it. However, we will reject project B since its NPV is negative.

With Real Options, we can discontinue project 1 when the market is bad after year 2 itself when negative cash flows are expected.

Thus, the cash flows will be

Thus, with real options, NPV can be increased to -$528.09 from -$3988.05 when the market is bad.

Thus, Expected NPV = 60% * 2713.57 - 40% * 528.09 = $1416.91

Value provided by real option = 1416.91- 32.92 = $1383.99

With Real Options, we can discontinue project 2 when the market is bad after year 1 itself when negative cash flows are expected.

Thus, the cash flows become:

Thus, with real options, NPV can be increased to -$480.18 from -$3934.78 when the market is bad.

Expected NPV = 60% * 2113.19 - 40% * 480.18 = $1075.84

Value provided by real option = 1075.84 + 306 = $1381.84

Project Cash Flows Discounted Cash Flows 0 -2896.15 -2896.15 1 727 637.72 2 2290 1762.08 3 1129 762.04 4 2037 1206.07 5 2391 1241.81 NPV $2713.57

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