Question

Flexability Options

Tropetech Inc. is looking at investing in a production facility that will require an initial investment of $500,000. The facility will have a three-year useful life, and it will not have any salvage value at the end of the project’s life. If demand is strong, the facility will be able to generate annual cash flows of $260,000, but if demand turns out to be weak, the facility will generate annual cash flows of only $125,000. Tropetech Inc. thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

1. If the company uses a project cost of capital of 11%, what will be the expected net present value (NPV) of this project?

1. -$22,189

2. -$20,710

3. -$19,230

4. -$29,585

Tropetech Inc. could spend $510,000 to build the facility. Spending the additional $10,000 on the facility will allow the company to switch the products they produce in the facility after the first year of operations if demand turns out to be weak in year 1. If the company switches product lines because of low demand, it will be able to generate cash flows of $255,000 in years 2 and 3 of the project.

2. What is the expected NPV of this project if Tropetech Inc. decides to invest the additional $10,000 to give themselves a flexibility option?

1. $90,283

2. $54,628

3. $60,698

4. $36,113

3. What will be the value of Tropetech Inc.’s flexibility option?

1. $90,283

2. $54,628

3. $81,255

4. $36,113

5. 60,698

Answer 1

Answer to Part 1

Computation of cash inflow per year -

NPV = -500000/(1+0.11)^0 + 192500/(1+0.11)^1 + 192500/(1+0.11)^2 + 192500/(1+0.11)^3

= -500000 + 192500/1.11 + 192500/1.2321 + 192500/1.367631

= -500000 + 173423.4 + 156237.3 + 140754.3

= -29584.9 or $ 29585

option (d) should be the right answer.

Answer to requirement 2

In this case calcualtion of Cash inflow per year -

cash inflow for year 1 = 125000*0.5 + 260000*0.5

= 62500 + 130000

= 192500

Cash inflow for year 2 & 3 = 255000*0.5 + 260000*0.5

= 127500 + 130000

= 257500

NPV = -510000/(1+0.11)^0 + 192500/(1+0.11)^1 + 257500/(1+0.11)^2 + 257500/(1+0.11)^3

= -510000 + 192500/1.11 + 257500/1.2321 + 257500/1.367631

= -510000 + 173423.4 + 208992.8 + 188281.8

= 60697.98 or $ 60698

option (c) should be the correct answer.

Answer to requirement 3

Value of Troptech's inc. flexibility option = NPV in requirement 1 + NPV in requirement 2

= 29585 + 60698

= $90283

option (a) should be the correct option.

please check with your answer and let me know.