Unformatted text preview: ted discount rate (RADR) applicable to
each plan. Plan Risk-adjusted
discount rate (RADR) X 13% Y 15% Further analysis of the two plans has disclosed that each has a real option
embedded within its cash flows.
Plan X Real Option—At the end of 3 years the firm could abandon this plan
and then install the automatic equipment, which would then have a proven
track record. This abandonment option is expected to add $100,000 of NPV
and has a 25% chance of being exercised.
Plan Y Real Option—Because plan Y does not require current expansion of
the plant, it creates an improved opportunity for future plant expansion. This
option allows the firm to grow its business into related areas more easily if
business and economic conditions continue to improve. This expansion
option is estimated to be worth $500,000 of NPV and has a 20% chance of
being exercised. Required
a. Assuming that the two plans have the same risk as the firm, use the following
capital budgeting techniques and the firm’s cost of capital to evaluate their
acceptability and relative ranking.
(1) Net present value (NPV).
(2) Internal rate of return (IRR).
b. Recognizing the differences in plan risk, use the NPV method, the riskadjusted discount rates (RADRs), and the data given earlier to evaluate the
acceptability and relative ranking of the two plans. CHAPTER 10 Risk and Refinements in Capital Budgeting 463 c. Compare and contrast your finding in parts a and b. Which plan would you
recommend? Did explicit recognition of the risk differences of the plans affect
d. Use the real-options data given above for each plan to find the strategic NPV,
NPVstrategic, for each plan.
e. Compare and contrast your findings in part d with those in part b. Did
explicit recognition of the real options in each plan affect your recommendation?
f. Would your recommendations in parts a, b, and d be changed if the firm
were operating under capital rationing? Explain. WEB EXERCISE
W Go to the Contingency Analysis Web site, www.contingencyanalysis.com. Scroll
down the page and click Fundam...
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