# 12-4sol - LEGEND PROBLEM 12-4 Original Strategy Answer a...

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LEGEND: Answer a. and b. New strategy without abandonment option \$(73.54) New strategy with abandonment option \$141.18 Answer c. Cost-overrun 0.53% Original Strategy (Build 2 in Year 1 and 2 in Year 2 and with no extra Year 0 1 2 Plant construction capacity per year 1 2 2 Plant construction costs (\$ millions) \$450 \$375 \$350 WACC for plant investments 13.770% Risk free rate 5.000% Convenience yield 3.000% Volatility 0.15 Up value multiple (u) 118.530% Down value multiple (d) 0.88 Risk neutral probability (up) 46.257% Actual Risk Neutral Probability (up price) 50.00% 46.26% Probability (down price) 50.00% 53.74% Present value of plant cash flows (\$ millions) \$320.00 Values of Each Energy Plant (\$ millions) (PV of expected future cash flows) Year 0 1 2 449.58 379.30 \$320.00 333.06 280.99 246.74 Analysis of the Valu Naïve Inflexible DCF Analysis Year 0 1 2 PROBLEM 12-4: Original Strategy New Strategy: Build 1 plant in Year 1 (extra 25 R&D) and Build 1 plant in Year 2 (extra R&D of 35)

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199.17 8.60 (130.00) (33.88) (188.02) (206.53) Number of plants to be built 1 1 1 Cost of constructing each plant \$450 \$375 \$350 Expected NPVs for each phase \$(130.00) \$(89.71) \$(18.78) PV of Annual Expected NPVs \$(130.00) \$(78.85) \$(14.51) Value of the Strategy (Year 0) \$(71.20) Enlightened Valuation of the Strategy Years 0 1 2 \$1,269.16 \$714.05 \$184.19 \$287.58 \$- \$- Noded value at Year 4--Max(NPV,0) Node value at Year 3 and earlier--Max of (i) 1. PV of expected payoff in next period plus NPV of current period or (ii) zero NPV (with abandonment option) is 184.19 American Option Payoffs (value) plus NPV of investing in the current period. If this sum is greater than zero then the firm should invest in this period. If it is negative then the strategy should be abandoned.
3 4 6 6 \$320 \$320 Solution Legend 3 4 = Value given in problem 534.30 = Formula/Calculation/Analysis required 450.77 = Qualitative analysis or Short answer require 395.82 = Goal Seek or Solver cell 394.78 = Crystal Ball Input 346.65 = Crystal Ball Output 292.46 256.81 216.66 190.25 ue of the Strategy Actual Probabilities Year 3 4 0 1 2 3 4 1,285.79 6.25% 784.61 12.50% Discussion A quick comparison of the present value of the strat traditional DCF analysis and its counterpart where w decision flexibility inherent in the ability of managem abandon the investments should future conditions n going ahead is striking. The traditional DCF analysis the present value of the strategy's cash flows is (\$5

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12-4sol - LEGEND PROBLEM 12-4 Original Strategy Answer a...

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