mini-case-ch12 - Chapter 12 Real Options MINI CASE Assume...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 12 Real Options MINI CASE Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options. Since no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics. To begin, you gathered some outside materials the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers. a. What are some types of real options? Answer: 1. Investment timing options 2. Growth options a. Expansion of existing product line b. New products c. New geographic markets 3. Abandonment options a. Contraction b. Temporary suspension c. Complete abandonment 4. Flexibility options. b. What are five possible procedures for analyzing a real option? Answer: 1. DCF analysis of expected cash flows, ignoring option. 2. Qualitatively assess the value of the real option. 3. Decision tree analysis. 4. Use a model for a corresponding financial option, if possible. 5. Use financial engineering techniques if a corresponding financial option is not available. Mini Case: 12- 1
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
c. Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 per year for three years. The cost of capital for this type of project is 10 percent and the risk-free rate is 6 percent. After discussions with the marketing department, you learn that there is a 30 percent chance of high demand, with future cash flows of $45 million per year. There is a 40 percent chance of average demand, with cash flows of $30 million per year. If demand is low (a 30 percent chance), cash flows will be only $15 million per year. What is the expected NPV? Answer: Initial Cost = $70 Million Expected Cash Flows = $30 Million Per Year For Three Years Cost Of Capital = 10% PV Of Expected CFs = $74.61 Million Expected NPV = $74.61 - $70 = $4.61 Million Alternatively, one could calculate the NPV of each scenario: Demand Probability Annual Cash Flow High 30% $45 Average 40% $30 Low 30% $15 Find NPV of each scenario: PV High: N=3 I=10 PV=? PMT=-45 FV=0 PV= 111.91 NPV High = $111.91 - $70 = $41.91 Million. PV Average: N=3 I=10 PV=? PMT=-30 FV=0 PV= 74.61 NPV Average = $74.61 - $70 = $4.71 Million. PV Low: N=3
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

Page1 / 11

mini-case-ch12 - Chapter 12 Real Options MINI CASE Assume...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online