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2. Abandonment options

Albert Co. is considering a four-year project that will require an initial investment of $12,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $26,000 per year, and the worst-case cash flows are projected to be $4,500 per year. The companys analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

What would be the expected net present value (NPV) of this project if the projects cost of capital is 14%?

$19,246

$20,448

$24,057

$22,854

Albert now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $3,000 (at the end of year 2). The $3,000 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the projects assets and the companys $4,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

$29,619

$24,233

$25,580

$26,926

What is the value of the option to abandon the project? -------------

3. Investment timing options

Companies often need to choose between making an investment now or waiting until the company can gather more relevant information about the potential project. This opportunity to wait before making the decision is called the investment timing option.

Consider the case:

St. Margaret Beer Co. is considering a three-year project that will require an initial investment of $41,000. If market demand is strong, St. Margaret Beer Co. thinks that the project will generate cash flows of $29,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,750 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

If the company uses a project cost of capital of 12%, what will be the expected net present value (NPV) of this project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)

-$3,297

-$2,777

-$3,471

-$3,818

St. Margaret Beer Co. has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.

What will be the expected NPV if St. Margaret Beer Co. delays starting the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)

$4,745

$7,425

$3,954

$3,559

What is the value of St. Margaret Beer Co.s option to delay the start of the project? (Note: Do not round intermediate calculations and round your answer to the nearest whole dollar.)

$3,559

$3,954

$4,745

$7,425

1. Growth options

Companies often come across projects that have positive NPV opportunities in which the company does not invest. Companies must evaluate the value of the option to invest in a new project that would potentially contribute to the growth of the firm. These options are referred to as growth options.

Consider the case of Scorecard Corp.:

Scorecard Corp. is considering a three-year project that will require an initial investment of $30,000. It has estimated that the annual cash flows for the project under good conditions will be $50,000 and $7,000 under bad conditions. The firm believes that there is a 60% chance of good conditions and a 40% chance of bad conditions.

If the firm is using a weighted average cost of capital of 13%, the expected net present value (NPV) of the project is . (Note: Round your answer to the nearest whole dollar.)

Scorecard Corp. wants to take a potential growth option into account when calculating the projects expected NPV. If conditions are good, the firm will be able to invest $6,000 in year 2 to generate an additional cash flow of $21,000 in year 3. If conditions are bad, the firm will not make any further investments in the project.

Using the information from the preceding problem, the expected NPV of this projectwhen taking the growth option into accountis$58,695 . (Note: Round your answer to the nearest whole dollar.)

Scorecard Corp.s growth option is worth----------- . (Note: Round your answer to the nearest whole dollar.)

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