Smarts Inc. is a leader in developing AI based solutions for businesses. It is currently evaluating the opportunity to develop a software system that would utilize both blockchain and AI technologies simultaneously. The initial investment required to develop this software is $5 million and the software will be ready in one years time. If the software system performs well (and results in high demand from businesses), Smarts anticipates that it will generate net cash flows of $2 million per year (starting one year from now) over the next ten years. However, if the systems performance only leads to low demand from customers, it will generate net cash flows of $500,000 per year over the next ten years. Due to the novel nature of the software, the likelihood of demand being high is only 30% and the appropriate cost of capital for Smarts is 10% per annum.

The NT government is keen for Smarts development team to be based in Darwin as it would like to promote Darwin (and NT) as an IT and software hub. It is therefore offering the company the ability to exit the operation at the end of the first year the government will buy the entire project (code, computers etc.) for $3 million.

a) Draw the decision tree relating to this project.

b) Calculate the net present value for the project with the option to exit. If Smarts took the project, would it exercise the option after the commencement of the project? Why or why not? Show all workings.

c) Using the approach discussed in the lecture, calculate the value of the real option that is being offered by the NT government? Show all workings.

d) Suppose that everything in the above example remains the same except that the NT government is offering to buy the entire project for $2 million at the end of the first year. What is the value now of the option to exit the project at the end of the first year? Explain this result from the viewpoint of the drivers of option values