Growth Option

Martin Development Co. is deciding whether to proceed with Project X. The cost would be $7 million in Year 0. There is a 50% chance that X would be hugely successful and would generate annual after-tax cash flows of $4 million per year during Years 1, 2, and 3. However, there is a 50% chance that X would be less successful and would generate only $1 million per year for the 3 years. If Project X is hugely successful, it would open the door to another investment, Project Y, which would require an outlay of $7 million at the end of Year 2. Project Y would then be sold to another company at a price of $14 million at the end of Year 3. Martins WACC is 9%.

a. If the company does not consider real options, what is Project Xs expected NPV?

b. What is Xs expected NPV with the growth option?

c. What is the value of the growth option?