Question

1. The Panhandle Corporation is considering whether to go ahead with a small-scale trial project that requires an initial outlay of $900,000 and, if successful produce cash inflows of $450,000 in year one followed by $540,000 per year in perpetuity starting at the end of year two. If not successful, the project will produce no cash flows. The probability of success is 38%. Given the extreme riskiness of this project the company decides to use 28% as a risk-adjusted discount rate for this project.
   1. Given the above information and based on static analysis, should the company go ahead with its investment?
   2. Upon further study the company realizes that, if the project was successful, it creates an opportunity to expand production by investing an additional $9 million at the end of year one. The new investment would increase the project cash flows to $2.20 million (instead of $540,000) per year in perpetuity. Also, at that point the company feels that a major part of the risk associated with the project would have been resolved and that from year one on it can use its WACC of 15%. Given this information, should the company go ahead with the investment?
   3. What is the present value of the option to expand?  

Answer 1