1. Given the projections in Exhibit 1, estimate the free cash flows of Penelopes first generation phone project.

You should assume that the annual depreciation of $900,000 is already included in the SG&A expenses every year from 2001 to 2006. You should also assume that the capital expenditure for the first generation project is $5,400,000 in 2001. In all other years, CAPEX is zero for this project. Given these assumptions and the projections in Exhibit 1, you should be able to verify that the free cash flow in 2001 (at the end of the first year) is -$10,000,000 as stated in the case.

2. What is the net present value of Penelopes first generation phone project if we ignore the possibility of investing in a second generation phone project (i.e., if we ignore the growth option)?

a. Calculate the NPV of the project by first assuming that the project will be terminated at the end of 2006 and it will generate no cash flows after 2006, i.e., the terminal value of the project as of 2006 is expected to be zero.

b. Calculate the NPV of the project by assuming that the project will be terminated at the end of 2004 and it will generate no cash flows after 2004, i.e., the terminal value of the project as of 2004 is expected to be zero. Assume that, in this case, the initial investment in net working capital ($1.5 million) is recovered at the end of 2004.

3. How large does the current present value of the second generation project (i.e., the value of the underlying asset of the growth option at the end of 2000) have to be in order to justify a $10 million investment in the first year on the first generation project? Assume that if the firm exercises its growth option to invest $100 million in the second stage project at the end of 2004, the first project will be terminated and there will be no cash flows from the first project after 2004. The initial investment in net working capital ($1.5 million) will be recovered at the end of 2004.

Hint: The value of the option to invest in the second project four years from now (end of 2000) should be at least equal to the NPV of the first generation project that you calculated in question 2b.

Repeat the same exercise by assuming that the volatility of cash flows a) increases to 75%; b) decreases to 25%. How does your answer change in both cases? Comment on this.

Note: Apply the Black-Scholes option valuation model only. Since you are not asked to apply the binomial option valuation model, you can ignore the statement ...expected value of cash flows....would either increase by 64.9% or decrease by 39.3% each year..., which is at the end of the case.

1. Given the projections in Exhibit 1, estimate the free cash flows of Penelope's first generation phone project. You should assume that the annual depreciation of $900,000 is already included in the SG\&A expenses every year from 2001 to 2006 . You should also assume that the capital expenditure for the first generation project is $5,400,000 in 2001. In all other years, CAPEX is zero for this project. Given these assumptions and the projections in Exhibit 1, you should be able to verify that the free cash flow in 2001 (at the end of the first year) is $10,000,000 as stated in the case. 2. What is the net present value of Penelope's first generation phone project if we ignore the possibility of investing in a second generation phone project (i.e., if we ignore the growth option)? a. Calculate the NPV of the project by first assuming that the project will be terminated at the end of 2006 and it will generate no cash flows after 2006 , i.e., the terminal value of the project as of 2006 is expected to be zero. b. Calculate the NPV of the project by assuming that the project will be terminated at the end of 2004 and it will generate no cash flows after 2004 , i.e., the terminal value of the project as of 2004 is expected to be zero. Assume that, in this case, the initial investment in net working capital ( $1.5 million) is recovered at the end of 2004 . 3. How large does the current present value of the second generation project (i.e., the value of the underlying asset of the growth option at the end of 2000) have to be in order to justify a $10 million investment in the first year on the first generation project? Assume that if the firm exercises its growth option to invest $100 million in the second stage project at the end of 2004 , the first project will be terminated and there will be no cash flows from the first project after 2004 . The initial investment in net working capital (\$1.5 million) will be recovered at the end 2004. Hint: The value of the option to invest in the second project four years from now (end of 2000) should be at least equal to the NPV of the first generation project that you calculated in question 2b. Repeat the same exercise by assuming that the volatility of cash flows a) increases to 75%; b) decreases to 25%. How does your answer change in both cases? Comment on this. Note: Apply the Black-Scholes option valuation model only. Since you are not asked to apply the binomial option valuation model, you can ignore the statement "...expected value of cash flows....would either increase by 64.9% or decrease by 39.3% each year...," which is at the end of the case. Penelope's Personal Pocket Phones Penelope Phillips sat in her laboratory at the University of the North and tried to determine whether she should start a company focussed on the next generation of wireless phone technology. Her work in electrical engineering and the 15 patents she held told her that she could enter the market with a new generation of phones. The problem was, however, that the market was quite competitive and she knew that it would therefore be difficult to succeed. Penelope understood that getting into the market today might lead to much bigger opportunities in the future. Penelope looked at her projections. In order to get the first generation to market she would have to invest $10 million in the first year. The cash flow forecasts in Exhibit 1 show what she expected to earn on this first product. Comparable firms in the industry had unlevered betas of around 1.2 and annual standard deviation of returns of 50%, so she set out to see if the investment was worth the time and energy. The 10-year Treasury bond was yielding 10.0% at the time. Penelope also knew that by starting the company today, she would have the opportunity to invest in the subsequent generation of phones. Given the expectations about future costs, this opportunity would take $100 million to bring to market. She estimated, however, that she would have to make the investment four years from now when the entire $100 million would have to be invested. She wondered how big the current expected value on the second-generation phone would have to be in order to justify investing in the proposed project. She set about trying to calculate that value. Thirty minutes into her calculations, Jay Thomas called to tell her that she would be able to start the project using equipment that could easily be sold for $4 million in year two if demand was not high for her phones. By year two, she could be reasonably confident of what the value of her first generation of phones would be; that is, she assumed that the value would be known with certainty at that time. If that were the case, Penelope wondered what the value of the first project would be. She decided to ignore the second-generation phones for a while and focus on this new problem. Did the possibility of selling the equipment at the end of year two make the first project worth it even if there were no follow-on project? If she modeled the annual change in value, Penelope figured that the expected value of cash flows from the first-generation phones would either increase by 64.9% or decrease by 39.3% each year. She wondered how to proceed with her analysis. Exhibit 1 Pro forma projections for Penelope's Personal Pocket Phones 1. Given the projections in Exhibit 1, estimate the free cash flows of Penelope's first generation phone project. You should assume that the annual depreciation of $900,000 is already included in the SG\&A expenses every year from 2001 to 2006 . You should also assume that the capital expenditure for the first generation project is $5,400,000 in 2001. In all other years, CAPEX is zero for this project. Given these assumptions and the projections in Exhibit 1, you should be able to verify that the free cash flow in 2001 (at the end of the first year) is $10,000,000 as stated in the case. 2. What is the net present value of Penelope's first generation phone project if we ignore the possibility of investing in a second generation phone project (i.e., if we ignore the growth option)? a. Calculate the NPV of the project by first assuming that the project will be terminated at the end of 2006 and it will generate no cash flows after 2006 , i.e., the terminal value of the project as of 2006 is expected to be zero. b. Calculate the NPV of the project by assuming that the project will be terminated at the end of 2004 and it will generate no cash flows after 2004 , i.e., the terminal value of the project as of 2004 is expected to be zero. Assume that, in this case, the initial investment in net working capital ( $1.5 million) is recovered at the end of 2004 . 3. How large does the current present value of the second generation project (i.e., the value of the underlying asset of the growth option at the end of 2000) have to be in order to justify a $10 million investment in the first year on the first generation project? Assume that if the firm exercises its growth option to invest $100 million in the second stage project at the end of 2004 , the first project will be terminated and there will be no cash flows from the first project after 2004 . The initial investment in net working capital (\$1.5 million) will be recovered at the end 2004. Hint: The value of the option to invest in the second project four years from now (end of 2000) should be at least equal to the NPV of the first generation project that you calculated in question 2b. Repeat the same exercise by assuming that the volatility of cash flows a) increases to 75%; b) decreases to 25%. How does your answer change in both cases? Comment on this. Note: Apply the Black-Scholes option valuation model only. Since you are not asked to apply the binomial option valuation model, you can ignore the statement "...expected value of cash flows....would either increase by 64.9% or decrease by 39.3% each year...," which is at the end of the case. Penelope's Personal Pocket Phones Penelope Phillips sat in her laboratory at the University of the North and tried to determine whether she should start a company focussed on the next generation of wireless phone technology. Her work in electrical engineering and the 15 patents she held told her that she could enter the market with a new generation of phones. The problem was, however, that the market was quite competitive and she knew that it would therefore be difficult to succeed. Penelope understood that getting into the market today might lead to much bigger opportunities in the future. Penelope looked at her projections. In order to get the first generation to market she would have to invest $10 million in the first year. The cash flow forecasts in Exhibit 1 show what she expected to earn on this first product. Comparable firms in the industry had unlevered betas of around 1.2 and annual standard deviation of returns of 50%, so she set out to see if the investment was worth the time and energy. The 10-year Treasury bond was yielding 10.0% at the time. Penelope also knew that by starting the company today, she would have the opportunity to invest in the subsequent generation of phones. Given the expectations about future costs, this opportunity would take $100 million to bring to market. She estimated, however, that she would have to make the investment four years from now when the entire $100 million would have to be invested. She wondered how big the current expected value on the second-generation phone would have to be in order to justify investing in the proposed project. She set about trying to calculate that value. Thirty minutes into her calculations, Jay Thomas called to tell her that she would be able to start the project using equipment that could easily be sold for $4 million in year two if demand was not high for her phones. By year two, she could be reasonably confident of what the value of her first generation of phones would be; that is, she assumed that the value would be known with certainty at that time. If that were the case, Penelope wondered what the value of the first project would be. She decided to ignore the second-generation phones for a while and focus on this new problem. Did the possibility of selling the equipment at the end of year two make the first project worth it even if there were no follow-on project? If she modeled the annual change in value, Penelope figured that the expected value of cash flows from the first-generation phones would either increase by 64.9% or decrease by 39.3% each year. She wondered how to proceed with her analysis. Exhibit 1 Pro forma projections for Penelope's Personal Pocket Phones