There is a 60 chance that the market for these

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million in a new technology to produce Everlasting Candies. There is a 60% chance that the market for these candies will produce profits of £100 million annually forever, a 20% chance the market will produce profits of £50 million annually forever, and a 20% chance that there will be no profits ever. The size of the market will become clear one year from now. There is no trade between their countries so none of them is affected by the investment decision the other makes. Sarah’s family has been in the candy business for five generations. The family business is in good shape and, although they like the idea of selling a new product, they are not in need for new products. They have decided to wait one year to reconsider the investment opportunity. The developer of the technology is keen to do business with Sarah and has agreed to wait for them to decide on the investment. Sarah’s family business has a cost of capital of 10% . Peter entered the candy market five years ago and has enough money to make the investment he is offered. His company is struggling to keep in pace with the competition and considers that waiting for one year without a breakthrough will lead the company to bankruptcy. Peter’s company has a cost of capital of 10% . 1. Discuss the decision making setting for each entrepreneur and how the existence of the option to wait af fects the appraisal of Sarah’s investment opportunity . In particular: a) Based on the NPV and real options approach, discuss how much of the project’s uncertainty each entrepreneur faces. Also discuss how this uncertainty affects the riskiness of the project for each of them. (10 marks) b) Based on your previous answer, explain why Sarah should use the real options approach to make her investment decision and why the project has a higher NPV for her than for Peter. Use theory and numerical examples to illustrate your arguments. (20 marks) END OF EXAMINATION
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