Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30 percent probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years.There is a 40 percent probability of medium conditions, in which case the annual cash flows will be $4 million, and there is a 30 percent probability of bad conditions and a cash flow of -$1 million per year. BSI uses a 12 percent cost of capital to evaluate projects like this.

Now suppose the original project could be delayed a year.All the cash flows would remain unchanged, but information obtained during that year would tell the company exactly which set of demand conditions existed.The cash flow and the cost of project will be shifted one year and the project will be implement only if we are in good condition.Estimate the value of the project if it is delayed by 1 year.The risk-free rate is 6% and the cost of capital is 12%

Problem 3:Using Decision Tree to estimate the value of real option (Option to wait one year and implement only if the demand is good)

probability T=1 T=2 T=3 T=3 NPV@T=0

Good 0.3

Medium 0.4

Bad 0.3

T=0 state prob T=1 T=2 T=3 T=4 PV@T=1

good 0.3

medium 0.4

bad 0.3

A)What is the expected NPV of project if wait one year and implement only if the demand is good?

B)What is the standard deviation of project's NPV?

C)What is the Coefficient Variation of the project?

Implement Today

Wait One Year

(Decision Tree)

Expected NPV

Standard Deviation

Coefficient Variation