Reliable Machinery Inc. is considering expanding its operations in Thailand. The initial analysis of the project...

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Reliable Machinery Inc. is considering expanding its operationsin Thailand. The initial analysis of the project yields thefollowing results:'
? The project is expected to generate $85 million in after-taxcash ?ows every year for the next 10 years.
? The initial investment in the project is expected to be $750million.
? The cost of capital for the project is 12%. If the projectgenerates much higher cash ?ows than anticipated, you will have theexclusive right for the next 10 years (from a manufacturinglicense) to expand operations into the rest of Southeast Asia. Acurrent analysis suggests the following about the expansionopportunity:
? The expansion will cost $2 billion (in current dollars).
? The expansion is expected to generate $150 million inafter-tax cash ?ows each year for 15 years. There is substantialuncertainty about these cash ?ows, and the standard deviation inthe present value is 40%.
? The cost of capital for this investment is expected to be 12%as well. The risk-free rate is 6.5%.
a. Estimate the net present value of the initial investment.
b. Estimate the value of the expansion option.

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4.2 Ratings (967 Votes)

a NPV of the initial investment initial investment PV of the cost of expansion 750 20001riskfree rate10 750 200016510 750 106545 181545 b Expansion option can be valued as a call option See Answer

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Reliable Machinery Inc. is considering expanding its operationsin Thailand. The initial analysis of the project yields thefollowing results:'? The project is expected to generate $85 million in after-taxcash ?ows every year for the next 10 years.? The initial investment in the project is expected to be $750million.? The cost of capital for the project is 12%. If the projectgenerates much higher cash ?ows than anticipated, you will have theexclusive right for the next 10 years (from a manufacturinglicense) to expand operations into the rest of Southeast Asia. Acurrent analysis suggests the following about the expansionopportunity:? The expansion will cost $2 billion (in current dollars).? The expansion is expected to generate $150 million inafter-tax cash ?ows each year for 15 years. There is substantialuncertainty about these cash ?ows, and the standard deviation inthe present value is 40%.? The cost of capital for this investment is expected to be 12%as well. The risk-free rate is 6.5%.a. Estimate the net present value of the initial investment.b. Estimate the value of the expansion option.