(Real options and capital budgeting) You have come up with agreat idea...

Solution a Valuation of Restaurant Option Particular Probability 1 Pr ....

(Real options and capital budgetingâ€‹) You have come up with a great idea for aâ€‹ Tex-Mex-Thai...

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(Real options and capital budgetingâ€‹) You have come up with agreat idea for aâ€‹ Tex-Mex-Thai fusion restaurant. After doing afinancial analysis of thisâ€‹ venture, you estimate that the initialoutlay will be $5.7 million. You also estimate that there is a 50percent chance that this new restaurant will be well received andwill produce annual cash flows of $760,000 per year foreverâ€‹ (aperpetuity), while there is a 50 percent chance of it producing acash flow of only â€‹$240,000 per year foreverâ€‹ (a perpetuity) if itâ€‹isn't received well.
a. What is the NPV of the restaurant if the required rate ofreturn you use to discount the project cash flows is 12â€‹percent?
b. What are the real options that this analysis may beâ€‹ignoring?
c. Explain why the project may be worthwhile even though youhave just estimated that its NPV isâ€‹ negative?

Answer & Explanation Solved by verified expert

4.2 Ratings (861 Votes)

Solution:

(a) Â Â

Valuation of Restaurant Option
Particular	Probability 1	Probability 2	Amount ($)
Cash Outflow			Â Â Â Â Â Â 5,700,000.00
Cash Inflow	Â Â Â Â Â Â Â Â Â Â Â Â Â Â 760,000.00	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 240,000.00
Expected Rate (Perpetuity) 12%	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.12	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.12
Discounted Cash Infow	Â Â Â Â Â Â Â Â Â Â 6,333,333.33	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 2,000,000.00
Probability	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.50	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.50
Expected Discounted Cash Inflow	Â Â Â Â Â Â Â Â Â Â 3,166,666.67	Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 1,000,000.00	Â Â Â Â Â Â 4,166,666.67

NPV of Restaurant			Â Â Â Â Â Â 1,533,333.33

NPV of restauarant is $1,533,333.33

(b) Normally Real Options are considered when we have either Expansion plan or Entering a new area of operations. But in this situation, this is the first time the restaurant is starting. So, according to me there is no need to consider real options here.

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