Question
Zamunda inc. is interested in investing in a developing country. The company estimates the investment would require an initial investment of $70 million. There is
Zamunda inc. is interested in investing in a developing country. The company estimates the investment would require an initial investment of $70 million. There is a 25% chance that the government of the developing country will impose a tax on all foreign businesses in the country in the near future. In this case, Zamunda inc. expects the investment to produce positive cash flows of $10 million a year at the end of each of the next 15 years. However, there is a 75% chance that the government will NOT impose the tax. In this case, Zamunda inc. expects the investment to produce positive cash flows of $18 million a year at the end of each of the next 15 years. The projects cost of capital is 13%. Use the information provided above on Zamunda inc. to answer questions 1(a), 1(b), 1(c) and 1(d).
1(a). What are the expected NPV, and the coefficient of variation of this project if Zamunda inc. has no real options?
1(b). Now suppose Zamunda inc is considering waiting for 4 years to find out about the tax situations in the country. If it waits 4 years, the projects up-front cost will remain at $70 million, the subsequent cash flows will remain at $10 million per year if the tax is imposed on foreign businesses and at $18 million per year if the tax is NOT imposed. In this case what is the expected NPV, the value of the option, and the CV of this project? Assume that WACC remains at 13%.
1(c).Now suppose this project cannot be delayed. But Zamunda inc will have the opportunity to rerun this project if the outcomes are favorable. In other words, there exists a growth option at the end of life of the project. In this case what is the expected NPV, the value of the option, and the CV of this project? Assume that WACC remains at 13%.
1(d). Now suppose that Zamunda inc just employed an economist who convinced the management team at the firm that the Black-Scholes options pricing model is a more accurate estimate of the values of real options. The firm the decide to use this method to analyze and estimate the value of the growth option. In this case, calculate the value option using the Black-Scholes options pricing model. Assume that WACC remains at 13%, the risk-free rate is 5%, variance of the project return is 0.1323.
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