The executives of Garner-Wagner Inc. are considering a project that will cost $85 million. The cost...

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The executives of Garner-Wagner Inc. are considering a projectthat will cost $85 million. The cost of capital for this type ofproject is 10 percent and the risk-free rate is 5 percent. There isa 50 percent chance of high demand, with future cash flows of $50million per year for 3 years. There is a 40 percent chance ofaverage demand, with cash flows of $30 million per year for 3years. If demand is low (a 10 percent chance), cash flows will beonly $20 per year for 3 years
a. What is the expected NPV?
b. If Garner-Wagner Inc makes the investment today, then it willhave the option to replicate the project at the end of project lifeif the demand is high. The cash flow will be repeated (i.e., thedemand will continue to be high).
Use decision-tree analysis to calculate the expected NPV of thisproject, including the option to replicate.
c. If Garner-Wagner Inc wants to use Black-Sholes formula toestimate the value of this real option, What would be the value ofP in the Blacksholes formula?
d. Estimate the variance in the Black-Sholes formula.

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4.4 Ratings (982 Votes)

No of Years	Nature of Demand	Probability	Quantity of Cash Flow	PV factor for 10% of expected return
1	50% of High	0.50	$50 Millions	0.909
2	50% of High	0.50	$50 Millions	0.826
3	50% of High	0.50	$50 Millions	0.751
4	40% of High	0.40	$30 Millions	0.683
5	40% of high	0.40	$30 Millions	0.621
6	40% of high	0.40	$30 Millions	0.564
7	10%of High	0.10	$ 20 Millions	0.513
8	10% of high	0.10	$20 Millions	0.467
9	10% of high	0.10	$20 Millions	0.424

Cost of Capital(Ke) = 10% and Risk free return (Rf) = 5%

1) Total Years cash flow= 0.50(50)+0.50(50)+ 0.50(50)+0.40(30)+0.40(30)+0.40(30)+0.10(20)+0.10(20)+0.10(20)

Present value of cash flows =25(0.909)+25(0.826)+25(0.751)+12(0.683)+12(0.621)+12(0.564)+2(0.513)+2(0.467)+2(0.424)

= 22.725+20.65+18.775+8.196+7.452+6.768+1.026+0.934+0.848

=$87.374

Expected NPV= Expected Cash flow - Initial Outlay= $87.374-$85= $2.347

2) Risk free rate of return is

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Transcribed Image Text

The executives of Garner-Wagner Inc. are considering a projectthat will cost $85 million. The cost of capital for this type ofproject is 10 percent and the risk-free rate is 5 percent. There isa 50 percent chance of high demand, with future cash flows of $50million per year for 3 years. There is a 40 percent chance ofaverage demand, with cash flows of $30 million per year for 3years. If demand is low (a 10 percent chance), cash flows will beonly $20 per year for 3 yearsa. What is the expected NPV?b. If Garner-Wagner Inc makes the investment today, then it willhave the option to replicate the project at the end of project lifeif the demand is high. The cash flow will be repeated (i.e., thedemand will continue to be high).Use decision-tree analysis to calculate the expected NPV of thisproject, including the option to replicate.c. If Garner-Wagner Inc wants to use Black-Sholes formula toestimate the value of this real option, What would be the value ofP in the Blacksholes formula?d. Estimate the variance in the Black-Sholes formula.