Chapter 18 Exercises

Step-by-Step Exercises

Expected Net Present Value Analysis

Multiply the present value of the cash flows associated with each outcome by the probability that it will occur, total the results, and subtract the net initial investment.

Question 1

Hickle Oil Company is deciding whether to spend $35,000,000 to invest in a drilling site. There is a 40% chance that the land will contain plentiful oil, in which case the present value of future cash flows from the site will be $80,000,000, and a 60% chance that the land will contain a small amount of oil, in which case the present value of future cash flows from the site will be $3,000,000.

Calculate the expected net present value of the investment.

Question 2

Avalon Investments is considering a $10,000,000 investment in a company that has a 75% chance of success. If it is successful, it will earn income of $2,000,000 per year for the next 10 years. If it is not successful, it will earn income of only $300,000 per year for the next 10 years. Avalon Investments has a 9% required rate of return.

Calculate the expected net present value of the investment.

Question 3

Carthage Research, which has a 12% required rate of return, has applied for a federal grant. There is a 25% chance that the grant will be fully funded, in which case it will provide $200,000 one year from now. There is a 40% chance that the grant will be partially funded, in which case it will provide $50,000 one year from now. In either case, if the research goes well, the grant will be renewed for an additional four years. Carthage estimates that there is a 70% chance that the research will go well.

Calculate the expected net present value of the grant.

Real Options Analysis

First, identify the possible outcomes and the firm’s available choices.

Question 4

Ruggers Productions is considering launching a new television series. If the series is popular enough, Ruggers could license elements of the show for merchandising, which would bring in extra revenue. If the series is not popular, Ruggers could cancel the show at any time.

Identify the possible outcomes and the firm’s available choices.

Question 5

Yahamba Technology is considering whether to invest in research and development for a new product. Yahamba knows that a competitor is developing a similar product, and Yahamba could probably only make significant income from the product if they beat the competitor to market. However, there is a chance that once the technology is developed, it could be used for another purpose.

Identify the possible outcomes and the firm’s available choices.

Question 6

Bullfrog Games is considering the development of a new kind of computer game. If the game catches on, Bullfrog sees the potential for creating similar games based on the same premise.

Identify the possible outcomes and the firm’s available choices.

Next, determine the present value of cash flows for each possible scenario.

Question 7

Crete Beverages, which requires an 8% rate of return on their investments, is considering changing the flavor of their most popular drink to one that their taste testers have determined tastes better. The reformulated drink would cost the same to produce as the current drink, but Crete would incur costs to redesign their labels to read “New! Better Flavor!” and retool their machinery for the label change. In addition, Crete would incur costs to advertise the new flavor. There is a good chance that customers will like the new taste enough that income will increase by $2,000,000 per year for the next 5 years, but there is also a chance that customers will be so upset that the drink has changed that income will decrease by $5,000,000 per year for the next 5 years. After a year of sales, Crete could decide to go back to the original drink flavor, at which point income will be the same as it was before the change.

Determine the present value of cash flows if (a) customers like the new taste and Crete continues the flavor, if (b) customers like the new taste and Crete discontinues the flavor, if (c) customers dislike the new taste and Crete continues the flavor, and if (d) customers dislike the new taste and Crete discontinues the flavor.

Question 8

Wabash Industries, which has a 10% required rate of return, is considering hiring a productivity specialist at an annual salary of $100,000 per year. The specialist demands a 10-year employment contract, claiming that she can save the company $800,000 per year in operating costs. After a 1-year period, Wabash can evaluate whether this is, in fact, the case, or if she saves the company nothing. Wabash could not fire the specialist but could choose to employ her in a different position, which they estimate would generate an additional $120,000 in income for the company.

Determine the present value of cash flows if (a) the specialist generates the savings and continues in her position, if (b) she generates the savings and is employed in a different position after one year, if (c) she does not generate the savings and continues in her position, and if (d) she does not generate the savings and is employed in a different position after one year.

Question 9

Miama Company, which requires a 12% return on all their new products, is considering launching a new product. There is a 70% chance that the product will generate income of $200,000 per year for the next 10 years, and a 30% chance that it will generate income of only $17,500 per year for the next 10 years. Miama must develop the production technology to produce the product before they can do focus group testing, which would indicate whether demand would be high or low. If Miama were to decide not to produce the product, the production technology could be sold for $100,000 at any time after it is developed.

Consider the project to start when focus testing occurs. Determine the present value of cash flows if (a) there is high demand and Miama continues with product sales, if (b) there is high demand and Miama sells the production technology, if (c) there is low demand and Miama continues with product sales, and if (d) there is low demand and Miama sells the production technology.

Next, determine which decision the firm will make on each branch of the decision tree.

Question 10

Willmer Corporation is performing real options analysis for a project under consideration. If the project is successful, the present value of future cash flows will be $4,000,000. If it is unsuccessful, the present value of future cash flows will be $(1,000,000). If the project is abandoned, it will generate no future cash flows.

Determine which decision the firm will make if the project is successful and if it is unsuccessful.

Question 11

Catoosa Company is performing real options analysis for a new product. If demand for the product is high, the present value of future cash flows will be $800,000. If demand for the product is low, the present value of future cash flows will be $200,000. Catoosa could expand the scope of sales after a year, which would have a present value cost of $100,000 but would increase the present value of future cash flows from the product by 30%.

Determine which decision the firm will make if demand for the product is high and if demand for the product is low.

Question 12

Wild Corn, Inc. is considering building an ethanol plant. If economic conditions are favorable, the present value of future cash flows from operating the plant will be $3,500,000. If economic conditions are not favorable, the present value of future cash flows from operating the plant will be $(5,000,000). Wild Corn could suspend operations until economic conditions become favorable in the future, which would result in future cash flows with a present value of $(500,000). If the plant is abandoned, the firm would have to pay for disposal of equipment; the present value of this cost is $700,000.

Determine which decision the firm will make if economic conditions are favorable and if economic conditions are not favorable.

Next, calculate the value of the project.

Question 13

Dodger Company is performing real options analysis on a project under consideration. There is a 20% chance that the present value of future cash flows will be $3,700,000 and an 80% chance that the present value of future cash flows will be $12,000,000. The investment will cost $8,000,000 up front.

Calculate the value of the project.

Question 14

Sillode Corporation is performing real options analysis on a project under consideration. There is a 40% chance that the present value of future cash flows will be $5,000,000 and a 60% chance that the present value of future cash flows will be $8,000,000. The investment will cost $7,000,000 up front.

Calculate the value of the project.

Question 15

Creeks, Inc. is performing real options analysis on a project under consideration. There is a 25% chance that the present value of future cash flows will be $0 and a 75% chance that the present value of future cash flows will be $7,500,000. The investment will cost $5,000,000 up front.

Calculate the value of the project.

Finally, calculate the value of any real options associated with the project.

Question 16

The expected net present value of a project is $20,000. The value of the project using real options analysis is $28,000.

Calculate the value of any real options associated with the project.

Question 17

The expected net present value of a project is $4,500,000. The value of the project using real options analysis is $4,620,000.

Calculate the value of any real options associated with the project.

Question 18

The expected net present value of a project is $284,000. The value of the project using real options analysis is $284,000.

Calculate the value of any real options associated with the project.

Complete Problems

Question 19

Crusher Company, which requires a 10% return on their projects, is considering starting a new product line, which would require a $2,000,000 up-front investment, and would generate sales over 5 years. There is a 25% chance that the product could do poorly, in which case annual revenues would be $750,000 and annual costs would be $400,000. There is a 75% chance that the product will do well, in which case annual revenues would be $1,500,000 and annual costs would be $600,000. The company will not know for certain whether the product is doing well or poorly until it has been on the market for a year. The production technology could then be converted for use in regular operations, which would cost $500,000 in Year 2, but would save the company $750,000 per year on their existing costs in Years 3 through 5.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Question 20

Firquell Corporation, whose required rate of return is 8%, is considering entering into a 10-year contract with a supplier, who will supply direct materials for $10 less than current market price as long as market prices stay above $100. If market prices drop below $100, the savings will drop to $5 less than market price. Firquell manufactures 200,000 units per year. Another supplier is willing to provide materials for $8 less than current market price regardless of market conditions, but Firquell must pay a cancellation fee of $1,500,000 to get out of the contract. Market prices are expected to remain constant for the time being, but because of expected improvements in technology, there is a 60% chance that it will drop to $90 after approximately 2 years.

1. Calculate the expected net present value of the contract.
2. Calculate the value of the contract using real options analysis.
3. Calculate the value of any real options associated with the contract.

Question 21

SuperSoft is considering developing a new operating system for cell phones. Because of the pace of technology, the software will be obsolete in 3 years, but there is a 20% chance that it will become obsolete after only 1 year. The operating system will cost $500,000 to develop and will generate income of $300,000 each year. If the software does become obsolete after a year, SuperSoft could sell their patent to another company during the second year, who could adapt the programming for other purposes. SuperSoft estimates that they can sell the patent for $100,000. SuperSoft has an 8% required rate of return.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Question 22

JellaCo, which has a required rate of return of 14%, is considering selling a new product. If demand for the product is high, income from the product will be $700,000 per year over the product’s 8-year life. If demand for the product is low, income from the product will be $200,000 per year. Development costs will total $2,000,000. JellaCo will make deals with suppliers that will require them to produce the product for 3 years, but at that point they could decide to cease production and sell the related assets for $800,000 during Year 4. JellaCo estimates that there is a 65% chance that demand will be high.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Question 23

Timpani, Inc. is considering investing in a new venture that will require $1,000,000 up front. The terms of the deal provide that Timpani will receive dividends of $400,000 per year for 5 years. However, Timpani believes that there is a 30% chance that the venture will go bankrupt after 2 years. If so, Timpani could choose to go to bankruptcy court to recover up to the full amount of the original investment. If they do so, Timpani will incur $100,000 in legal fees (in the third year) and would probably have only a 25% chance of recovery. Timpani has a 10% required rate of return.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Question 24

Couliphant, Inc. has a required rate of return of 12%. Couliphant is considering starting a new product line, which Couliphant expects (with a 70% likelihood) will produce revenues of $800,000 per year over the product’s 10-year life, with annual costs of $350,000, all variable. If things do not go as well as expected, the revenues and variable costs will be half what was expected. Development costs for the product would total $1,400,000. After two years of sales, Couliphant could add a second product as an add-on to the first, which would bring in half the income of the first product. The second product would cost $700,000 to develop in year two, and income from the product would begin in year three and last through the rest of the original product’s life.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Assignment Problem

Note: Check figures are not provided for assignment problems so your instructor may use them for homework.

Question 25

Robinson Manufacturing, which has a 12% required rate of return, is planning to invest in a new manufacturing facility. The facility would cost $2,000,000 to build and would require fixed costs of $400,000 per year to operate. The facility would be used to produce goods that could generate a contribution margin of $950,000 per year for the next 10 years. However, Robinson estimates that there is a 20% chance that demand for the company’s products will not be sufficient to support production at the new plant in addition to the existing plant, which would result in the facility’s generating no additional sales. If this is the case, Robinson could choose to suspend operations at the new facility, which would reduce fixed costs by 75% while operations are suspended. Robinson would discover the demand for the product by the time the facility is complete.

1. Calculate the expected net present value of the project.
2. Calculate the value of the project using real options analysis.
3. Calculate the value of any real options associated with the project.

Challenge Problem

Question 26

Merriwether Developers, which has a 10% required rate of return, has the opportunity to purchase a parcel of land for $1,200,000, a bargain because the land is not zoned. If Merriwether does not take the opportunity, another firm will. The land is scheduled for a zoning hearing a year from now. If the land is zoned as residential, it will be worth $1,300,000 immediately after zoning. In this case, Merriwether could build an apartment complex at a cost of $2,000,000. If the land is zoned as commercial, it will be worth $2,200,000 immediately after zoning. In this case, Merriwether could build a strip mall at a cost of $2,500,000. Either development would be completed 1 year after zoning. Both would be expected to have a life of 10 years once completed. The apartment complex would bring in annual revenues of $675,000 and incur annual costs of $135,000. A rival developer is considering building a shopping center near the land in 5 years. If the shopping center is not built, the strip mall would bring in average annual revenues of $2,500,000 and incur average annual costs of $1,750,000. If the shopping center is built, it would dilute the market, and the strip mall would bring in average annual revenues of $1,800,000 and incur average annual costs of $1,180,000 after the competitor enters the market (starting in Year 6). Merriwether’s best estimate is that there is a 70% chance that the land will be zoned as commercial, and a 35% chance that the rival developer will build the shopping center. Merriwether can sell the land at any point for the value mentioned above ($1,200,000 before zoning, $1,300,000 after zoning if zoned residential, $2,200,000 if zoned commercial); any development of the land would not affect its value if it is sold.

Expected Net Present Value Analysis

(Note: The initial cost of the land should not be included.)

1. Find the expected net present value of the land without any developments.
2. Find the expected net present value of the future cash flows associated with:
   1. The apartment complex
   2. The strip mall
   3. The development overall

Real Options Analysis

3. Find the value of the project using real options analysis.
4. Find the value of any real options associated with the project.

PRE-ASSESSMENT PROBLEM

Use this problem to check whether you are fully prepared for the assessment. Work the problem under assessment conditions – don’t use any notes or other materials!

Question 27

SuCo is considering marketing a new product that will require an up-front investment of $250,000 to acquire the production technology. This technology could be sold at 60% of its investment value if the project is discontinued. If demand for the new product is high, net cash flows will be $100,000 per year, and if it is low, net cash flows will be $25,000 per year. SuCo estimates that there is a 60% chance demand will be high, but will learn which outcome will actually occur through focus testing, only days before product launch would occur. The project is expected to last 7 years, and SuCo’s required rate of return is 14%.