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 $5.6 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 $780,000 per year forever​ (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only $200,000 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 11 ​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?

***PLEASE, ONLY ANSWER THIS QUESTION IF YOU KNOW HOW TO DO IT AND PLEASE BE AS DETAILED AS POSSIBLE.***

Answer 1

1	2	3=1*2
Amount	Probability	Amount
7,80,000.00	0.5	3,90,000.00
2,00,000.00	0.5	1,00,000.00
Total		4,90,000.00

Initial outlay	56,00,000.00	$
Probable inflow for perpetuity	4,90,000.00	$
Rate	11	%
Present value for perpetuity	Cashflow/rate

Present value for perpetual cashflow	490000/.11
=	44,54,545.45	$
NPV of the project	Discounted Inflow - Outflow
=	4454545.45 - 5600000
	-11,45,454.55	$
So the project has negative cash flow

B) In the present case cash flows are infinite i.e., to perpetuity. And we are discounted the cash flows using a constant rate. We can’t expect a rate that it will be constant for infinity.

NPV systematically undervalues everything due to simple assumptions. NPV ignores options to expand, abandon and defer projects and also all expected cash flows are pre-determined.

But in Real option analysis (ROA) uses decision trees to model optimal actions in the future given the resolution of uncertainty and ROA works backward to arrive at the optimal deferral decision. NPV uses constant discount rate while ROA changes the discount rate if necessary.

So in this case NPV result should not be considered for the project

C) The NPV method is not applicable when comparing projects that have perpetual cash flows. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project. Company should also consider the qualitative factors too. The problem with using the NPV method is that it requires guessing about future cash flows and estimating a company's cost of capital.

When comparing projects that have different life spans, NPV approach is difficult to apply. How can you compare a project that has positive cash flows for five years versus a project which is expected to produce cash flows for perpetuity?

So this project should be accepted even if the NPV is negative for the project.