Dear Tutor,

I have a problem with my homework, since I dont know how to complete this excercise. Could you help?

1. A manufacturing plant in Sicily will cost 90 million to build. The fixed costs of operating the plant will be 25 million per year. Projected net revenues (revenues minus variable costs) are 35 million per year (the probability of the projected case is 50%). However, net revenues could turn out to be as high as 45 million (optimistic case) or as low as 20 million (pessimistic case). The probabilities of the optimistic and pessimistic outcomes are each 25%. Assume for simplicity that cash flows are level perpetuities. Ignore taxes. The cost of capital is 12%.

a. Would you go ahead and build the factory if it has no value in any other use? (Hint: calculate the NPV. You will need to discount the future net cash flows, which in this case will be calculated as net revenue minus fixed costs of operating the plant.)

b. Suppose that the factory could be shut down and sold for 50 million in year 2, after actual net revenues are revealed. Now would you build the factory? (Assume that if the plant is closed the $50 million will be received at the end of year 1.)