A firm introduces a new product and must enter the market now to secure a niche but it will not know the demand for the product until after a year. There is a 75% chance that demand will be high and a 25% chance that it will be low. If demand is high, same firm will earn $4M in the first year, after which a decision must be made to keep the project as is and not expand. If it does not expand, PV of cash flow at the end of year one will be $16M. If it takes advantage of high demand to expand, the cost will be $2M and cash flow at year end will be $30M. If demand is low, said project will earn $0.8M in the first year and a decision must be made to keep project as is and not terminate. If the project is not terminated, PV of cash flow will be $3M in year one. If the company decides to terminate, cost of termination will be $0.5M and PV of cash flow from liquidation of project will be $6M at the end of year one.

ACCT3501

A.

B.

i. ii.

i. ii.

Draw a decision tree for this project. (7 marks) Determine the value of the real options. (8 marks)

Briefly explain what is meant by a real option in capital budgeting. Give TWO (2) examples. (3 marks)

Why is it important to consider real options in the capital budgeting process?