NPV = $60,156.46

PI = 1.0461

IRR = 15.91%

MIRR = 15.52%

PBP = 5.55 years

DPBP = 9.75 years

The Ballpark Company is a little disheartened by the fact that the projects NPV is not high enough to provide a high level of confidence in the projects success. The project managers also note that, at 15.52%, the MIRR is too close to the RRR that a slight error in estimating the cost of capital might cause the NPV to be negative and the MIRR to be below RRR.

1. One of the rising stars within the division, Pat Walters, is having problems accepting the way her superiors have dealt with the land/building as opportunity costs at the beginning, then as assets that would be sold (and incur taxes) at the end of the life of the project. She thinks that de-bundling the land from the building is not a practical thing to start with (you cant sell the land separately from selling the building). She raises the issue with one of her superiors and she is told that that was not a big issue: bundle them together and put them as one asset and they would still have the same combined ATSV. She seemed to be initially persuaded with that line of thinking.

However, something keeps her awake that night thinking there is still something that didnt seem right about the land/building combination. Then in the wee hours of the morning it hits her: Ballpark is a bowling ball manufacturer, and they are very good at what they do, but the company is not a real estate agency or developer and, therefore, had no business evaluating how the value of the building and land will evolve over the next ten years. The following day she does a little more research and meets with a commercial real estate agent who tells her that if her company wants to rent the building (including the land plot of course), the rent would be $30,000 today and would rise by a rate consistent with the long-term inflation rate of 3.50% per year.

She sits at her desk and recalculates NPV, PI, IRR, and MIRR (not paybacks) using the rent as an opportunity cost and she is buoyed by the fact that her NPV more than doubled!

Task I: Can you replicate what this bright rising star did, given the above information?

(Hint on how to prepare this part of your solution in Excel: copy your original solution up to the MIRR decision onto a new Excel worksheet and do the necessary adjustments there, keeping the original solution intact. You dont need to do NPV profiles again).

2. Encouraged, Ms. Walters digs even deeper. She is aware that the way the project managers estimated the number of units expected to be sold in year one (37,500 units) was the result of a probability-weighted average of two possible outcomes: 46,500 units with a probability of 60% and 24,000 units with a probability of 40% (verify that this is actually the case). She does a little research on her own and finds out that there exist some embedded options in the proposed project:

1. As a first step, she finds out that one-year after the beginning of production, if the unit sales realized are the lower end of the estimate (i.e. 24,000 units) nothing prevents the company from stopping the project, release the land and building for other uses by the company and sell the equipment at 95% percent its total initial installed cost of $960,000.

2. She further discovers that, if the market for colored bowling balls prove strong by the end year one (as reflected in 37,500 unit sales rather than 24,000), there would be room for expansion by adding more productive capacity: investing another $960,000 in new equipment for a new ten-year period, thus doubling the size of the cash flows generated from the colored balls in years two to ten in addition to one single cash flow from the expansion equipment for year eleven. By doing this, the company would be exercising an expansion option that would have a healthy value for Ballpark. Better yet, Ms. Walters discovers that the structure where the equipment would be housed can also accommodate the expansion equipment (at no extra opportunity rent cost).

Task II. Show how recognition of these options changes the estimate of the Projects NPV. Given the results in tasks I and II, what is the value today of the combined abandonment and expansion options?

(Hint on how to prepare this part of your solution in Excel: copy your Task I solution up to the NPV decision onto a third Excel worksheet and do the necessary adjustments there, keeping the other two worksheets intact. Do both options together where the up branch of the decision tree is eleven years with 46,500 units and the down branch is cut at the end of year one after selling only 24,000 units. You dont need to redo PI, IRR, and MIRR for this task.)

For both tasks assume that all growth rates in units, price, and variable cost are the same as originally given.