Question

(Real options and capital budgeting​) You have come up with a great idea for a​ Tex-Mex-Thai fusion restaurant. After doing a financial analysis of this​ venture, you estimate that the initial outlay will be $5.7 million. You also estimate that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $760,000 per year forever​ (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only ​$240,000 per year forever​ (a perpetuity) if it​ isn't received well.

a. What is the NPV of the restaurant if the required rate of return you use to discount the project cash flows is 12 ​percent?

b. What are the real options that this analysis may be​ ignoring?

c. Explain why the project may be worthwhile even though you have just estimated that its NPV is​ negative?

Answer 1

Solution:

(a)   

Valuation of Restaurant Option
Particular	Probability 1	Probability 2	Amount ($)
Cash Outflow			5,700,000.00
Cash Inflow	760,000.00	240,000.00
Expected Rate (Perpetuity) 12%	0.12	0.12
Discounted Cash Infow	6,333,333.33	2,000,000.00
Probability	0.50	0.50
Expected Discounted Cash Inflow	3,166,666.67	1,000,000.00	4,166,666.67
NPV of Restaurant			1,533,333.33

NPV of restauarant is $1,533,333.33

(b) Normally Real Options are considered when we have either Expansion plan or Entering a new area of operations. But in this situation, this is the first time the restaurant is starting. So, according to me there is no need to consider real options here.

(c) This Project has Positive NPV of  $1,533,333.33. So, this project is worthy.