PLC is an electric bike manufacturer which considers investing in a new production line. The investment is irreversible but can be delayed by one year. The only reason why the project will be delayed by the firm’s management is the realization of a low growth state of the economy. The initial set-up cost of the production line is £1.5 million (mln), and the only outgoing costs are £0.25mln and £0.35mln one year and two years after the launch of the line, respectively. The investment’s output (in £’mln) is influenced by the economic environment, and is predicted to be as follows State Probability in 1 year in 2 years high growth 0.6 1.10 1.25 forever low growth 0.4 0.80 0.60 forever Each cash flow occurs at the beginning of the year in which it occurs. Risk-free rate is 10%. The appropriate rate of return for this investment is not known, but its risk profile is similar to another Linear Dynamics plc investment, Project Delta, with the following cash flows and Present Values: Project Delta (risky) Year Cash Flow Present Value 1 150 130.43 2 200 151.23
a) Find the appropriate rate of return for the production line investment.
b) What is the value of the production line if there is no option to delay?
c) What is the value of the option to delay? Is it advisable to delay the investment?