fm13 21 - and the non-risky cost to replicate (i.e., the...

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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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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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