Assume you have just been hired as a financial analyst c. Tropical Sweets is considering a project tnat wiII by Tropical Sweets Inc., a mid-size California company cost $70 million and will generate expected cash that specializes in creating exotic candies from tropical flows of $30 million per year for 3 years. The fruits such as mangoes, papayas, and dates. The firm's cost of capital for this type of project is 10%, CEO, George Yamaguchi, recently returned from an and the risk-free rate is 6%. After discussions industry corporate executive conference in San Francis- with the marketing department, you learn that co, and one of the sessions he attended addressed real there is a 30% chance of high demand with options. Because no one at Tropical Sweets is familiar associated future cash flows of $45 million per with the basics of real options, Yamaguchi has asked year. There is also a 40% chance of average you to prepare a brief report that the firm's executives demand with cash flows of $30 million per year can use to gain a cursory understanding of the topic. as well as a 30% chance of low demand with To begin, you gathered some outside materials on the cash flows of only $15 million per year. What is subject and used these materials to draft a list of ques- the expected NPV? tions that need to be answered. Now that the questions d. Now suppose this project has an investment timing have been drafted, you must develop the answers. option, because it can be delayed for a year. The a. What are some types of real options? cost will still be $70 million at the end of the year, b. What are five possible procedures for analyzing a and the cash flows for the scenarios will still last real option? 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Perform a the end of its life. What is the total expected NPV qualitative assessment of the investment timing of the two projects if both are implemented? option's value. h. Tropical Sweets will replicate the original project only e. Use decision-tree analysis to calculate the NPV of if demand is high. Using decision-tree analysis, estithe project with the investment timing option. mate the value of the project with the growth option. f. Use a financial option pricing model to estimate i. Use a financial option model to estimate the value the value of the investment timing option. of the project with the growth option. g. Now suppose that the cost of the project is j. What happens to the value of the growth option if $75 million and the project cannot be delayed. the variance of the project's return is 0.142 ? What However, if Tropical Sweets implements the if it is 0.50 ? How might this explain the high valuproject, then the firm will have a growth option: ations of many start-up high-tech companies that the opportunity to replicate the original project at have yet to show positive earnings