I need this answer by Friday night, if possible.
Sue with X company has just completed an evaluation has just been
completed of a proposed capital expenditure for equipment that would
expand the firm's manufacturing capacity. Using the traditional NPV
methodology, she found the project unacceptable be cause
NPV traditional = -$1,700<$0
Before recommending rejection of the proposed project, she has decided
to assess whether there might be real options embedded in the firm's
cash flows. Her evaluation uncovered the following three options.
Option 1: Abandonment- The project could be abandoned at the end of 3
years, resulting in an addition to NPV of $1,200.
Option 2: Expansion- If the projected outcomes occurred, an
opportunity to expand the firm?s product offerings further would occur
at the end of the 4 years. Exercise of this option is estimated to add
$3,000 to the project?s NPV.
Option 3: Delay- Certain phases of the proposed project could be
delayed if the market and competitive conditions caused the firm?s
forecast revenues to develop more slowly than planned. Such delay in
implementation at that point has a NPV of $10,000.
Sue estimated that there was a 25% chance that the abandonment option
would need to be exercised, a 30% chance the expansion option would be
exercised, and only a 10% chance that the implementation of certain
phases of the project would have to be delayed.
a. Use the information provided to calculate the strategic NPV, NPV
strategic, for X company products? proposed equipment expenditure.
b. Judging on the basis of your findings in part a, what action should
Sue recommend to management with regard to the proposed equipment
expenditures?
c. In general, how does this problem demonstrate the importance of
considering real options when making capital budgeting decisions? |
