Question
It is 1 January 2018 and you are considering investing $700,000 in a new winery and you have gathered the following data. There is 70%
It is 1 January 2018 and you are considering investing $700,000 in a new winery and you have gathered the following data. There is 70% chance that demand for your product will be high in the first year. If it is high in the first year then it will remain high for the remaining 9 years of the projects life. If demand is high in the first year then you will have a one-off opportunity of investing $300,000 in additional land at the end of the first year which will increase net cash flows from $150,000 to $250,000 per annum with the enhanced cash flow commencing exactly 2 years after the additional investment is made. If you dont take advantage of this one-off opportunity then cash flows will remain unchanged for the rest of the projects life. If demand is low in the first year then it will remain low for the rest of the projects life and will deliver only $80,000 per annum. You have negotiated the right but not the obligation to sell the land back to the vendor for a discounted amount of $450,000 and exit the project at the end of the first year if demand is low.
The required rate of return from this project is 15% per annum.
(a) On the basis of the information above estimate the value today of the expansionary right(s) contained in the project. [show all calculations]
(b) What is the incremental wealth created (or lost) today if you go ahead with this project?
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