Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because:

NPV Subscript traditional Baseline equals negative $ 1 comma 072 less than 0NPVtraditional=$1,072<0

Before recommending rejection of the proposed project, she has decided to assess whether real options might be embedded in the firm's cash flows. Her evaluation uncovered three options and their probability:

Option 1:

Abandonmentlong dashThe

project could be abandoned at the end of 3 years, resulting in an addition to NPV of

$ 1 comma 050$1,050.

Option 2:

Growthlong dashIf

the projected outcomes occurred, an opportunity to expand the firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add

$ 3 comma 760$3,760

to the project's

NPV.

Option 3:

Timinglong dashCertain

phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of

$ 9 comma 200$9,200.

Jenny estimated that there was a

20 %20%

chance that the abandonment option would need to be exercised, a

25 %25%

chance that the growth option would be exercised, and only a

5 %5%

chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategic NPV,

NPV Subscript strategicNPVstrategic,

for Asor Products' proposed equipment expenditure.

b. On the basis of your findings in part

(a),

what action should Jenny recommend to management with regard to the proposed equipment expenditure?

c. In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?