Real Options Exercise: Help is appreciated!

You are the assistant to the Premier.The province is contemplating developing a new cobalt mine somewhere in the province to supply raw material to an electric car battery factory to be built in one of the cities. Unfortunately, forecasts show that the mine will have a negative NPV of $3 million.

"The mine doesn't make it on financial grounds," says the Premier "but my gut tells me that we should do it."

"You're missing an important financial advantage," you tell your boss.

"What?" says the Premier.

"If we don't develop the mine, we won't be able to secure raw material to manufacture electric car batteries, and the state of Nevada, with its vast mineral resources, will get ahead of us and build the expertise to lead the electric car battery industry.The mine would give us not only its own cash flows but also the option to compete in the electric car battery industry."

The value of an electric car battery factory is highly uncertain, with a standard deviation of 0.4.The expected present value of the cash inflows of the factory is $1.5 billion. The decision to build the factory must be made in two years, at a required investment of $2 billion. Assume that the risk-free rate is currently 3%

Calculate:

a)What the option to build the electric car battery factory is worth; and

b)The strategic (expanded) NPV of the cobalt mine.

What should the province do?