A project requires an investment of $150 million and has expected annual cash flows of $35 million for 5 years, starting in one year.

The company can expand the project by investing another $150 million in year 5 and will then earn the same expected cash flows as before for another 5 years, starting in year 6. Based on its observation of demand, however, the company will be able to tell in year 5 if future cash flows will be either $15 million or $84 million per year.

The appropriate discount rate for the project is 6% and the risk-free rate is 4%.

Part 1: What is the NPV of the project ignoring the option to expand (in $ million)?

Part 2: What is the value of the follow-on project in year 5 in the up state (in $ million)?

Part 3: What is the up factor (u) in the binomial option valuation model? Hint: It should be a number greater than 1.

Part 4: What is the option exercise value in the up state if the company expands the project after 5 year (in $ million)?

Part 5: What is the risk-neutral probability of the up movement?

Part 5: What is the value of the option to expand (in $ million)?