Question

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 $840,000 per year forever​ (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only $160,000 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

a]Expected NPV = (probability of success * NPV if success) + (probability of not success * NPV if not success).

NPV in each case = present value of perpetual cash flows - initial outlay.

The present value of perpetual cash flows = annual cash flow/discount rate.

Expected NPV = [(($840,000 / 12%) - $5,700,000) * 50%] + [(($160,000 / 12%) - $5,700,000) * 50%] = -$1,533,333.33

b] The real option is that the project can be abandoned after 1 year if it is not received well.

c] The project may be worthwhile because if the value of the real option is considered, the expected NPV may be positive.