Question

Related to Checkpoint​ 13.5) ​ (Real options and capital​ budgeting)  You are considering introducing a new​ Tex-Mex-Thai fusion restaurant. The initial outlay on this new restaurant is

​$6.96.9

million and the present value of the free cash flows​ (excluding the initial​ outlay) is

​$5.35.3

​million, such that the project has a negative expected NPV of

​$1.61.6

million. Upon closer​ examination, you find that there is a

5555

percent chance that this new restaurant will be well received and will produce annual cash flows of

​$805 comma 000805,000

per year forever​ (a perpetuity), while there is a

4545

percent chance of it producing a cash flow of only

​$199 comma 000199,000

per year forever​ (a perpetuity) if it​ isn't received well. The required rate of return you use to discount the project cash flows is

10.110.1

percnet. ​ However, if the new restaurant is​ successful, you will be able to build

1515

more of them and they will have costs and cash flows similar to the successful​ restaurant's costs and cash flows.

a.  In spite of the fact that the first restaurant has a negative​ NPV, should you build it​ anyway? Why or why​ not?

b.  What is the expected NPV for this project if only one restaurant is built but​ isn't well​ received? What is the expected NPV for this project assuming

1515

more are built if the first restaurant is well​ received? ​ (Ignore the fact that there would be a time delay in building additional new​ restaurants.)

Answer 1

ANSWER :-

No,you will not build 10 more restaurant with a negative NPV as all restaurant have similar cash flow and investment.

(2)

Expected NPV = Present vaue of cash flow -Initial investment

                          =(199,000/.101) - 6,900,000

                          = 1,970,297-6,900,000

                         =$ - 4,929,703

Expected NPV = - 4,929,703* .45 = $2,218,366

(B)

NPV = present value of cash flow - Initial investment

            = (805,000 / .101) - 6,900,000       

            = 7,970,297-6,900,000

            =$ 1,070,297

Expected NPV - 1,070,297*.55 *15 REST. = $8,829,950

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