Problem 3. You are a member of the investment committee for a large manufacturing company that three years ago licensed a new technology from a small start-up firm. Based on that technology, engineers in one of your company's divisions have developed a new product that is now ready to be manufactured and marketed. The division president has recommended proceeding with the project. Your committee has to decide whether to endorse this recommendation and approve the request for funds. If you do not proceed with the product, the licensor has the right to suspend your license and attempt to market the technology to another manufacturer.

The product launch will require an initial investment of $225 million for manufacturing, marketing and distribution, and working capital. Net after-tax cash flows are expected to be $15, $20, and $25 million in the first three years of operation as new capacity comes on stream. In all successive years, net cash flow is expected to grow at 3% per year. The hurdle rate for new investment in your company's core business is 10%. However, your committee considers this project riskier than the core business and has stipulated that a 15% hurdle rate will apply.

The headquarters analyst assigned to examine the project has submitted a report showing that, at 15%, the NPV of the proposed investment is negative. However, the division president has taken strong exception to this analysis. She has requested a meeting with the committee at which she and her chief engineer and marketing VP can present their arguments in favor of the project. In a memo to the committee chair, she outlined her objections to the analyst's report.

First, she argued, the discount rate is wrong. The committee's insistence on 15% is unfair and, even worse, myopic. In her view, the project should be treated the same (at least) as other projects, which suggests a 10% hurdle rate. Further, given the project's strategic importance to the division, an even lower rate (she suggests 8%) would be justified. [The risk-free rate is 5%.]

Second, she argued that the analyst's cash flows are wrong. The new product is an important part of the division's future plans. After three years, once the original capacity is fully utilized, she can add twice again as much capacity for less than twice the additional expenditure. Specifically, an additional investment of $405 million will result in cash flows of $30, $40, and $50 million in the next three years, followed by a perpetuity that would start at $51.5 and grow at 3% per year. Three years after this second investment, the division can invest another $770 million and receive net cash flows of $60, $80, and $100 million in the subsequent three years, followed by a perpetuity growing at 3% per year. As before, this adds twice again the capacity at less than twice the previous investment. Thus, the memo emphasized, within ten years the division will have built a new business producing annual net cash flow of nearly $200 million.

The division president was prepared to come to the meeting and argue first, that her assumptions were appropriate, and second, that the NPV of launching the product was obviously positive. The committee chair then asked the analyst to respond to the president's memo.

In a second report, the analyst defended his original figures. It was perfectly legitimate, he argued, to separate the sequence of investments because each could be analyzed on its own merits. Indeed, only the first investment of $225 million was now before the committee. Nevertheless, he

claimed to be indifferent about whether he evaluated them separately (see Table A) or added them all together (see Table B). Discounting at 15%, none of the three investments had a positive NPV and so neither did the whole program. At 10%, the $225 million investment currently under consideration had a negative NPV. The other two had positive NPVs, but they might never happen and, in any event, the NPV of all three added together was still not much above zero. Of course, the program looked better at 8%, and the committee was free to accord it the special treatment requested by the division president. But the analyst respectfully observed that a new product launch could hardly be regarded as less risky than the established core business. Accordingly, he could see no justification for lowering the hurdle rate. Even if 15% was too high, surely 10% was too low. At any rate between these two, the project was unimpressive.

Table A
Round 1
	Year	0	1	2	3	4	5	6	7	8	9
	Cash Flow	0	15	20	25	25.8	26.5	27.3	28.1	29	29.9
	Investment	-225
	Net Cash Flow	-225	15	20	25	25.8	26.5	27.3	28.1	29	29.9
Round 2
	Year	0	1	2	3	4	5	6	7	8	9
	Cash Flow				0	30	40	50	1.5	53	54.6
	Investment				-405
	Net Cash Flow				-405	30	40	50	1.5	53	54.6
Round 3
	Year	0	1	2	3	4	5	6	7	8	9
	Cash Flow							0	60	80	100
	Investment							-770	0	0	0
	Net Cash Flow							-770	60	80	100
Table B
Rounds 1-3
	Year	0	1	2	3	4	5	6	7	8	9
	Cash Flow	0	5	20	25	55.8	66.5	77.3	139.6	162	184.5
	Investment	-225	0	0	-4045	0	0	-770	0	0	0
	Net Cash Flow	-225	15	20	-380	55.8	66.5	-692.7	139.6	162	184.5

a. Evaluate the proposed product launch using a standard discounted cash flow approach. In particular, compute the proposal's NPV at each of the three discount rates under consideration. What do you expect the committee to conclude, assuming it employs this basic methodology?

b. Estimate the NPV of the program as a portfolio of options. Assume that, though you are unsure of the standard deviation for the return on the assets under consideration, you are confident that ! is at least 0.3 per year, and no more than 0.6. Based on this approach, what decision would you recommend to the committee?

[Hint: This problem is more complicated, but similar to the example presented in the first section of Brealey and Myers' Chapter 21.1 For simplicity, you may wish to ignore, at first, the opportunity to invest $770 million in year 6, and focus only on the first two rounds of investment.]

c. How should the year 6 opportunity be incorporated into an options-based analysis of the whole program?

d. How would you explain and justify the options-based approach to your fellow committee members?