( Real options and capital budgeting) You have come up with a great idea for a t
ID: 2765994 • Letter: #
Question
( Real options and capital budgeting) You have come up with a great idea for a tax-max-Thai fusion restaurant. After doing a financial analysis of this venture, you estimate that the initial outlay will be $6 million. You also estimate that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $800,000 per year forever perpetuity), while there is a 50 percent chance of it producing a cash flow of only $ 200,000 per year forever (a perpetuity) if it isn’t received well. a. What is the NPV of the restaurant if the required rate of return you use to discount the project cash flows is 10 percent? b. What are the real options that this analysis may be ignoring? c. Explain why the project may be worthwhile even though you have just estimated that its NPV is negative.
Explanation / Answer
a. Initial Outlay = $6,000,000
Discount Rate = 10%
Prob(This go well) = 50%
FCF if things go well = $800,000 perpetuity
Prob(This go poorly) = 50%
FCF if things go poorly = $200,000 perpetuity
Expected FCF = $800,000 × 0.5 + $200,000 × 0.5 = $500,000
Expected NPV = $500,000 ÷ .10 – $6,000,000
= $5,000,000 – $6,000,000 = –$1,000,000
NPV if things go well = $800,000 ÷ 0.10 – $6,000,000 = $2,000,000
NPV if things go poorly = $2,000,000 ÷ 0.10 – $6,000,000 = –$4,000,000
What are the real options that this analysis may be ignoring?
b. If the project goes well, its NPV will be $2 million
, while if it goes poorly, its NPV will be negative $4 million.
Since there is a 50 percent chance of going well and going poorly, the expected NPV = $2,000,000 × 0.5 + –$4,000,000 × 0.5= –$1,000,000 as determined before.
However, if the project is received poorly, the restaurant chain will be abandoned. On the other hand, if it is favorably received, the firm will build 20 new restaurants. Thus the expected NPV is:.
NPV = 1 restaurant × (NPV restaurant received poorly) × Prob. it is received poorly + 20 restaurants × (NPV restaurant received well) × Prob. it is received well
= 1 × –$4,000,000 × 0.5 + 20 × $2,000,000 × 0.5
= –$2,000,000 + $20,000,000 = $18,000,000
Explain why the project may be worthwhile even though you have just estimated that its NPV is negative.
c. Thus, while the NPV is negative, if the firm has the ability to expand on this project if it is received well, then it should be taken on. In effect, if it is not received well, simply build the first restaurant and then abandon the project. If it is received well, build 19 more restaurants just like it, each with an expected NPV of $2 million.
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