A company is considering investing $100 million in a new production facility for launching one of its established products in a new market. Historically, within one year the company knows with certainty whether the product introduction to a new market is successful or not, with the probability for the former being 40 percent. The present value of the future discounted expected cash flows from the product net sales is either $200 million if the market is favorable one year from now, or $60 million otherwise. The required rate of return for this investment is 20 percent.

a. Determine the NPV of this investment at time zero. Should the company invest in this project?

b. Next, assume that if the market is unfavorable one year from now, the company can abandon the investment and redeploy the relevant assets to other sites. By doing so, it can recover 70 percent of the value of its original capital investment. Should the company now invest in this project?

c. Now assume that if the market is favorable one year from now, the company could double the plant’s capacity, making an additional capital expenditure of $85 million. In this case, the present value of the future discounted expected cash flows from the product net sales would increase by 50 percent. How should the company proceed now with this investment? What is the investment’s NPV with the inherent flexibility?

In problems 2 to 5, please use the logic of options through decision trees and classical discounted cash flows techniques—rather than a formal real options valuation approach—to approximate the value of options available to the corresponding investments.