A project requires an investment of $110 million and has expected annual cash flows of $20 million for 7 years, starting in one year. The company can expand the project by investing another $110 million in year 7 and will then earn the same expected cash flows as before for another 7 years, starting in year 8. Based on its observation of demand, however, the company will be able to tell in year 7 if future cash flows will be either $7 million or $60 million per year. The appropriate discount rate for the project is 7% and the risk-free rate is 3%.

a. What is the NPV of the project ignoring the option to expand (in $ million)?

b. What should the company do? a. Reject the project b.Cannot say, need more information c.Accept the project\

c. What is the value of the follow-on project in year 7 in the up state (in $ million)?

d. What is the up factor (u) in the binomial option valuation model? Hint: It should be a number greater than 1.

e. What is the risk-neutral probability of the up movement?

f. What is the option exercise value in the up state if the company expands the project after 7 year (in $ million)?

g. What is the value of the option to expand (in $ million)?

h. What should the company do?

a. Start the project and the follow-on project

b. Start the project, but not the follow-on project

c. Cannot say, need more information

d. Start the project, then decide about expansion later

e. Reject the project