Ch 25 Toolkit - Chapter 25. Tool Kit for Real Options THE...

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Chapter 25. Tool Kit for Real Options WACC= 14% Risk-free rate = 6% Initial cost of project= $50 DCF Analysis Expected annual cash flows (in millions): Probability Cash Flow Prob. x CF 25% $33 $8.25 50% $25 $12.50 25% $5 $1.25 Expected CF = $22.00 Time Line Year 0 1 2 3 Expected CF ($50) $22.00 $22.00 $22.00 NPV = $1.08 Figure 25-1 DCF and Decision Tree Analysis for the Investment Timing Option (Millions of Dollars) Part 1. Scenario Analysis: Proceed with Project Today Future Cash Flows NPV of this Now: Year 0 Year 1 Year 2 Year 3 Probability $33 $33 $33 $26.61 0.25 High -$50 Average $25 $25 $25 $8.04 0.50 Low $5 $5 $5 -$38.39 0.25 THE INVESTMENT TIMING OPTION: AN ILLUSTRATION (Section 25.2) Murphy Systems is considering a project that will create a new type of hand-held device for conn the Internet. The cost of the project is $50 million, but the future cash flows are uncertain. Murp estimates a 25% probability that the new Internet device will be very popular in which case the p generate cash flows of $30 million each year for three years. There is a 50% probability generati flows of $25 million each year for three years. Unfortunately, there is a 25% chance that the Inte will not be popular, which means that the project will generate only $5 million per year in cash fl cost of capital for this project is 14%. Scenario c 0. 25 0. 0. 5 0
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1.00 Expected value of NPVs = Part 2. Decision-Tree Analysis: Implement in One Year Only If Optimal Future Cash Flows NPV of this Now: Year 0 Year 1 Year 2 Year 3 Year 4 Probability -$50 $33 $33 $33 $23.35 0.25 High Wait Average -$50 $25 $25 $25 $7.05 0.50 Low $0 $0 $0 $0 $0.00 0.25 1.00 Expected value of NPVs = Notes: Figure 25-2 Sensitivity Analysis for the Investment Timing Option Decision Tree (Millions of Dollars) Future Cash Flows NPV of this Now: Year 0 Year 1 Year 2 Year 3 Year 4 Probability -$50 $33 $33 $33 $20.04 0.25 High Average -$50 $25 $25 $25 $3.74 0.50 Low $0 $0 $0 $0 $0.00 0.25 Standard Deviation a = Coefficient of Variation b = Scenario d Standard Deviation a = Coefficient of Variation b = a The standard deviation is calculated as in Chapter 6. b The coefficient of variation is the standard deviation divided by the expected value c The WACC is 14%. d The NPV in Part 2 is as of Year 0. Therefore, each of the project cash flows is disc back one more year than in Part 1. Part 1. Decision-Tree Analysis: Implement in One Year Only If Optimal (Discount Cost at the Risk-Free Rate and Operating Cash Flows at the WACC) Scenario c 2 5 0. 25 0. 25 0. 5 0 0 . 2 5 0. 0. 50
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1.00 Expected value of NPVs = Cost of Capital Used to Discount the Year 1 Cost $6.88 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 8.0% $13.11 $13.46 $13.80 $14.14 $14.47 $14.79 9.0% $11.78 $12.13 $12.47 $12.81 $13.14 $13.47 10.0% $10.50 $10.85 $11.20 $11.53 $11.86 $12.19 11.0% $9.27 $9.62 $9.97 $10.30 $10.64 $10.96 12.0% $8.09 $8.44 $8.78 $9.12 $9.45 $9.78 13.0% $6.95 $7.30 $7.64 $7.98 $8.31 $8.64 14.0% $5.85 $6.20 $6.54 $6.88 $7.21 $7.54 15.0% $4.79 $5.14 $5.48 $5.82
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This note was uploaded on 06/11/2011 for the course FIN 5560 taught by Professor A during the Spring '11 term at Nova Southeastern University.

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Ch 25 Toolkit - Chapter 25. Tool Kit for Real Options THE...

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