CHAPTER 11 CASE STUDY

Further analysis of the two plans has disclosed that each has a real option embedded within its cash flows. Plan X Real Option-At the end of 3 years the firm could abandon this plan and install the automatic equipment, which by then would have a proven track record. This abandonment option is expected to add $100,000 of NPV and has a 25% chance of being exercised. Plan Y Real Option-Because plan Y does not require current expansion of the plant, it creates an improved opportunity for future plant expansion. This option allows the firm to grow its business into related areas more easily if business and economic conditions continue to improve. This growth option is estimated to be worth $500,000 of NPV and has a 20% chance of being exercised. To Do a. Assuming that the two plans have the same risk as the firm, use the following capital budgeting techniques and the firm's cost of capital to evaluate their acceptability and relative ranking. (1) Net present value (NPV). (2) Internal rate of return (IRR). b. Recognizing the differences in plan risk, use the NPV method, the risk-adjusted discount rates (RADRs), and the data given earlier to evaluate the acceptability and relative ranking of the two plans. c. Compare and contrast your finding in parts (a) and (b). Which plan would you recommend? Did explicit recognition of the risk differences of the plans affect this recommendation? d. Use the real-options data given above for each plan to find the strategic NPV, NPVstrategic, for each plan. e. Compare and contrast your findings in part d with those in part (b). Did explicit recognition of the real options in each plan affect your recommendation? f. Would your recommendations in parts (a), (b), and (d) change if the firm were operating under capital rationing? Explain