13-10 OTHER TOPICS IN CAPITAL BUDGETING 21st century Educational Products (21 st Century) is a rapidly growing software company, and consistent with its growth, it has a relatively large capital budget. Although most of the company's projects are fairly easy to evaluate, a handful of projects involve more complex evaluations. John Keller, a senior member of the company's finance staff, coordinates e evaluation of these more complex projects. His group brings their recommendations directly to the company's CFO and CEO, Kristin Riley and Bob Stevens, respectively. a. In recent months, Keller's group has focused on real option analysis. 1. What is real option analysis? 2. What are some examples of projects with real options? b. Considering real options, one of Keller's colleagues, Barbara Hudson, has suggested that instead of investing in Project X today, it st might make sense to wait 1 year because 21 Century would learn more about market conditions and would improve its forecast of the st project's cash flows. Right now 21 century forecasts that Project X ll generate expected cash flows of $33,500 for 4 years. However, if the company waits 1 year, it will learn more about market conditions. There is a 50% chance that the market will be strong and a 50% chance that it will be weak If the market is strong, the annual cash flows will be $43,500. If the market is weak, the annual cash st flows will be only $23,500. If 21 Century chooses to wait 1 year, the initial investment will remain $100,000, and cash flows will continue for 4 years after the initial investment is made. Assume st that all cash flows are discounted at 10%. Should 21 Century invest in Project X today, or should it wait a year before deciding whether to invest in the project? c. Now assume that there is more uncertainty about the future cash flows. More specifically, assume that the annual cash flows are $53,500 if the market is strong and $13,500 if the market is weak Assume that the up-front cost is still $100,000 and that the WACC is still 10%. Will this increased uncertainty make the firm more or less willing to invest in the project today? Explain. st d. 21 Century is considering another project, Project Y. Project Y has an up-front cost of $200,000 and an economic life of 3 years. If the company develops the project, its after-tax operating costs will be $100,000 a year; however, the project is expected to produce after tax cash inflows of $180,000 a year. Thus, the project's estimated cash flows are as follows 13-10 OTHER TOPICS IN CAPITAL BUDGETING 21st century Educational Products (21 st Century) is a rapidly growing software company, and consistent with its growth, it has a relatively large capital budget. Although most of the company's projects are fairly easy to evaluate, a handful of projects involve more complex evaluations. John Keller, a senior member of the company's finance staff, coordinates e evaluation of these more complex projects. His group brings their recommendations directly to the company's CFO and CEO, Kristin Riley and Bob Stevens, respectively. a. In recent months, Keller's group has focused on real option analysis. 1. What is real option analysis? 2. What are some examples of projects with real options? b. Considering real options, one of Keller's colleagues, Barbara Hudson, has suggested that instead of investing in Project X today, it st might make sense to wait 1 year because 21 Century would learn more about market conditions and would improve its forecast of the st project's cash flows. Right now 21 century forecasts that Project X ll generate expected cash flows of $33,500 for 4 years. However, if the company waits 1 year, it will learn more about market conditions. There is a 50% chance that the market will be strong and a 50% chance that it will be weak If the market is strong, the annual cash flows will be $43,500. If the market is weak, the annual cash st flows will be only $23,500. If 21 Century chooses to wait 1 year, the initial investment will remain $100,000, and cash flows will continue for 4 years after the initial investment is made. Assume st that all cash flows are discounted at 10%. Should 21 Century invest in Project X today, or should it wait a year before deciding whether to invest in the project? c. Now assume that there is more uncertainty about the future cash flows. More specifically, assume that the annual cash flows are $53,500 if the market is strong and $13,500 if the market is weak Assume that the up-front cost is still $100,000 and that the WACC is still 10%. Will this increased uncertainty make the firm more or less willing to invest in the project today? Explain. st d. 21 Century is considering another project, Project Y. Project Y has an up-front cost of $200,000 and an economic life of 3 years. If the company develops the project, its after-tax operating costs will be $100,000 a year; however, the project is expected to produce after tax cash inflows of $180,000 a year. Thus, the project's estimated cash flows are as follows