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Problem 2 (10 marks) Your firm is thinking of expanding. If you invest today, the expansion will generate $11 million in FCF at the end
Problem 2 (10 marks) Your firm is thinking of expanding. If you invest today, the expansion will generate $11 million in FCF at the end of the year and will have a continuation value of either $145 million (if the economy improves) or $50 million (if the economy does not improve). If you wait until next year to invest, you will lose the opportunity to make $11 million in FCF, but you will know the continuation value of the investment in the following year (that is, in a year from now, you will know what the investment continuation value will be in the following year). Suppose the risk-free rate is 4%, and the risk-neutral probability that the economy improves is 37%. Assume the cost of expanding is the same this year or next year. If the cost of expanding is $83 million, should you do so today, or wait until next year to decide? a) [5 marks] b) At what cost of expanding would there be no difference between expanding now and waiting? To what profitability index does this correspond? [5 marks] Problem 2 (10 marks) Your firm is thinking of expanding. If you invest today, the expansion will generate $11 million in FCF at the end of the year and will have a continuation value of either $145 million (if the economy improves) or $50 million (if the economy does not improve). If you wait until next year to invest, you will lose the opportunity to make $11 million in FCF, but you will know the continuation value of the investment in the following year (that is, in a year from now, you will know what the investment continuation value will be in the following year). Suppose the risk-free rate is 4%, and the risk-neutral probability that the economy improves is 37%. Assume the cost of expanding is the same this year or next year. If the cost of expanding is $83 million, should you do so today, or wait until next year to decide? a) [5 marks] b) At what cost of expanding would there be no difference between expanding now and waiting? To what profitability index does this correspond? [5 marks]
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