Your company is planning to produce a new action figure called \"Hilliary\". The

Question

Your company is planning to produce a new action figure called "Hilliary". The initial cost of the production is $100 million which includes the purchase of equipment and the rights to produce the figure. The demand for the product, however, is uncertain. If it is a hit. the project will bring in net cash flows of $40 million per year for 5 years (starting at the end of year 1. If it fails, the project will only produce net cash flows of $10 million per year for 2 years (starting at the end of year 1). There a 60% chance that it will be a hit and a 40% chance that it will be a failure. You will not know whether it is a hit or a failure until thirst year's cash flows are in. Suppose the company will have an opportunity to sell the equipment for $60 million once the first year's cash flows are received. The project's opportunity cost of capital is 10%. Calculate the project's NPV ignoring the abandonment option. Estimate the project's NPV with the abandonment option. Calculate two examples of how alert financial managers can create real options for a project. Explain why these real options can be valuable. The optical scam company forecasts an 18 percent sales growth rate for next year. The current financial statements are shown below. Current assets, fixed assets, and short-term debt are proportional to sales.

Explanation / Answer

Case 1Calculation of NPV: Year Cash Flow PVAF10% Amount Year0 ($100) 1 ($100) Year1 $40 0.9091 $36.3640 Year2 $40 0.8264 $33.0560 Year3 $40 0.7513 $30.0520 Year4 $40 0.6830 $27.3200 Year5 $40 0.6209 $24.8360 Total $51.6280 Probablility 0.6 NPV $30.98 Casalculation of NPV Year Cash Flow PVAF10% Amount Year0 ($100) 1 ($100) Year1 $10 0.9091 $9.0910 Year2 $10 0.8264 $8.2640 Total ($83) Probability 0.4 NPV ($33.06)

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