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# fm13 21 - and the non-risky cost to replicate(i.e the \$75...

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Mini Case: 13 - 21 h. Tropical Sweets will replicate the original project only if demand is high. Using decision tree analysis, estimate the value of the project with the growth option. Answer: The future cash flows of the optimal decisions are shown below. The cash flow in year 3 for the high demand scenario is the cash flow from the original project and the cost of the replication project. 0 1 2 3 4 5 6 High -\$75 \$45 \$45 \$45 -\$70 \$45 \$45 \$45 Average -\$75 \$30 \$30 \$30 \$0 \$0 \$0 Low -\$75 \$15 \$15 \$15 \$0 \$0 \$0 To find the NPV, we discount the risky cash flows at the 10 percent cost of capital,
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Unformatted text preview: and the non-risky cost to replicate (i.e., the \$75 million) at the risk-free rate. NPV high = -\$75 + \$45/1.10 + \$45/1.10 2 + \$45/1.10 3 + \$45/1.10 4 + \$45/1.10 5 + \$45/1.10 6- \$75/1.06 3 = \$58.02 NPV average = -\$75 + \$30/1.10 + \$30/1.10 2 + \$30/1.10 3 = -\$0.39 NPV average = -\$75 + \$15/1.10 + \$15/1.10 2 + \$15/1.10 3 = -\$37.70 Expected NPV = 0.3(\$58.02) + 0.4(-\$0.39) + 0.3(-\$37.70) = \$5.94. Thus, the option to replicate adds enough value that the project now has a positive NPV....
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