You are a telecommunication company considering an investment into 1st generation GSM (analog mobile phone coverage) network. You need to buy the license from the government and build the infrastructure, for total investment of EUR 400 million today and you will receive net cash inflows of EUR 100 million at the end of each of next five years, after which the investment will be worthless. The appropriate discount rate for this project is 10%, while the risk-free rate is 5%. If (and only if) you invest today into the 1st generation network, you will be able (but not obliged) to invest into the 2nd generation (digital) network in five years. Then, the needed investment will be EUR 800 million and you expect to get net cash inflow of EUR 200 million in each of the five years following the investment. As mobile phones are a new industry in your country, you see great growth potential, but also large uncertainty in the future cash flow development. Your analysts believe, based on comparable projects and industries, that the most appropriate volatility (standard deviation) of the cash inflows/value is 25% per year.

(a) Calculate NPVs for both generations of GSM networks (i.e. for 1st and 2nd generations at the time of actual and initial investment).

(b) State the problem in terms of real options and identify key parameters needed to quantify option value. Calculate the real option value using the BlackScholes formula.

(c) Make a recommendation whether investing in the 1st generation network makes sense and explain why (not).