Overview

April Longmeadow, CEO of Wildcat Pizza, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the company's manufacturing capacity.Using the traditional NPV methodology, she found the project unacceptable because

Traditional NPV =- $1700< 0

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

Option 1:Abandonment

The project could be abandoned at the end of three years, resulting in an addition to NPV of $1,200

Option 2:Growth

If the projected outcomes occurred, an opportunity to expand the company's product offerings further would become available at the end of four years.Exercise of this option is estimated to add $3,000 to the project's NPV.

Option 3: Timing

Certain phases of the proposed project could be delayed if market and competitive conditions caused the company's forecast revenues to develop more slowly than planned.Such a delay in implementation at that point has an NPV of $10,000.

Sarah estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the growth option would be exercised, and only a 10% chance that the implementation of certain phases of the project would affect timing.

1. Use the information provided to calculate the strategic NPV for Wildcat's proposed equipment expenditure.
2. Judging on the basis of your findings in part 1, what action should Sarah recommend to the Board of Directors with regard to the proposed equipment expenditure?
3. In your opinion, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?