Question
Option to expand the branch: The original project was: New Food Inc. plans to open a new a new restaurant in North Dakota. The initial
Option to expand the branch:
The original project was: New Food Inc. plans to open a new a new restaurant in North Dakota. The initial costs of opening the business is $9.0 million. The firm estimates a 26% probability of high demand for the new food. In this case New Food Inc. will receive annual cash flows of $14.5 million for the next 2 years. The firm estimates a 53 probability of medium demand. In this case the company expects to receive annual cash flows of $7.8 for 2 years. There is also possible that the demand will be low and the annual cash flows will be only $1.3 million for 2 years. The company's cost of capital is 10.74 percent.
Option to expand the project: Now the company evaluating the possibility to expand the project if the original project is successful. The company plans to invest another $9.0 million at the end of year 2 (beginning of year 3) of the project to receive the same cash flows of $14.5 million for additional 2 years (years 3 and 4) in the case of high demand or to get $7.8 million for additional 2 years (years 3 and 4) in the case of medium demand. However, if the project was not successful during the first 2 years, the company will not expand the project for additional 2 years.
The company is absolutely certain about the size of the additional investment at the end of year 2, so he management is using risk-free rate as a discount rate for the costs.
Risk free rate is 3.10 percent.
Initial outlay at time point 0 in millions
| Probability | Additional Investment at the end of year Year 1 in millions | Additional Investment at the end of Year 2 in millions |
26% | $0 | $9.0 | |
$9.0 | 53% | $0 | $9.0 |
Please calculate it | $0 | $0 |
Calculate expected PV of costs of the project (initial outlay and additional investment at the end of yeaar 2).
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