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

Question

Your company is planning to produce a new action figure called "Hillary". 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 highly 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 is 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 the first 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 the value of the project's abandonment option. Give two examples of how alert financial managers can create real options for a project. Explain why these real options can be valuable.

Explanation / Answer

NPV = -2.08

NPV = -$2.08 million

b. Project's NPV with abandonment option = -$20 million

c. Value of project's abandonment option = $88 million

d. The flexibility available to management – i.e. the actual "real options" – generically, will relate to project size, project timing, and the operation of the project once established.[8] In all cases, any (non-recoverable) upfront expenditure related to this flexibility is the option premium. Real options are also commonly applied to stock valuation .  

Hit Failure Time in years (t) 10% Cash flow Present value Cash flow Present value 0 1.0000 -100 (100.00) 1 0.9091 24 21.82 4 3.64 2 0.8264 24 19.83 4 3.31 3 0.7513 24 18.03 4 0.6830 24 16.39 5 0.6209 24 14.90 NPV 20.00 (9.02) 8 6.94

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