Question
Consider an investment opportunity that requires a $100 million investment at time T. If you take it at time T, you will find out whether
Consider an investment opportunity that requires a $100 million investment at time T. If you take it at time T, you will find out whether it is successful in T+1. If the project succeeds, it will generate $1million per year in perpetuity starting from T+1. The probability of success if 70%. If the project fails, it will generate nothing. If the project succeeds, you will have learned valuable design and manufacturing knowledge, whereupon you have the choice to invest in another follow-on project at time T+1. The required investment in it is $10 million, and it will generate $1 million per year in the next ten years starting from time T+1. Your cost of capital is 8%.
(a) Calculate NPV if you take the initial investment at time T.
(b) Calculate the present value of the new project at time T.
(c) With the option to expand, calculate part (a) again.
(d) Compare (a) and (c), what is the value of the option to expand.
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