You are given the outcome estimates for a two-phase project that starts with an 18-month R&D phase and is followed with a 5-year operation phase. The cash outlay for the R&D study is $12.5M. And the company will invest an additional $80.0M to put the operation facility in place at the end of the R&D phase. If the R&D study is successful, which is expected to have a probability of 0.75, the expected semi-annual cash flows will be $15.0M during the operation phase. If the study fails, the expected semi-annual cash flows will be $10.0M during the operation phase. The discount rate is 14.4%, compounded monthly.

Compute the NPV of the 2-phase project (at t=0) assuming that the project will be implemented regardless of the outcome of the R&D study. Given the value of the 5-year $15.0M annuity is $103.341M at the beginning of the operation phase.

Now, you are given the option to build an upgraded operation facility at a cost of $110.0M (instead of the original facility) if the R&D study fails, but you will stay with the original facility if the study is successful. The upgraded facility is expected to generate semi-annual cash flows of $15.0M during the operation phase. Compute (i) the NPV of the project that is embedded with the real option, and (ii) the value of the real option to upgrade. Precisely explain why or why not the option to upgrade changes your recommendation on the project.

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