The New England Brewing Company produces a super premium beer using a recipe that’s been in the owner’s family since colonial times. Surprisingly, the firm doesn’t own its brewing facilities, but rents time on the equipment of large brewers who have excess capacity. Other small brewers have been doing the same thing lately, so capacity has become difficult to find, and must be contracted several years in advance.

New England’s sales have been increasing steadily, and marketing consultants think there’s a possibility that demand will really take off soon. Last year’s sales generated net cash flows after all costs and taxes of $5 million. The consultants predict that sales will probably be at a level that will produce net cash flows of $6 million per year for the next three years, but they also see a 20% probability that sales could be high enough to generate net cash inflows of $8 million per year. Meeting such an increase in demand presents a problem because of the advance contracting requirements for brewing capacity. Unless New England arranges for extra facilities now, there’s a 70% chance that brewing capacity won’t be available if the increased demand materializes. An option arrangement is available with one of the large brewers under which it will hold capacity for New England until the last minute for an immediate, nonrefundable payment of $1 million. New England’s cost of capital is 9%.

a. Draw a decision tree reflecting New England’s cash flows for the next three years without the option, and calculate the expected NPV of operating cash flows. (Note that there’s no need to include an initial outlay because we’re dealing with ongoing operations.)

b. Redraw the decision tree to include the capacity option as a real option in your calculations. What is its value? Should it be purchased?

c. Does the real option reduce New England’s risk in any way?