Question

You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a decision on a long-term government contract, your revenues will either increase by 20% or decrease by 25%, with equal probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.

A) If you are awarded the government contract and your sales increase by 20%,

then the value of your plant is ________$ million. (round to the nearest million)

B) If you are not awarded the government contract and your sales decrease by 25%,

then the value of your plant is__________ $ million. (round to the nearest million)

C) Given the embedded option to sell the plant, what is the value of your plant?

The value is _______$ million. (round to one decimal)

D) Assume that you are not able to sell the plant, but you are able to shut down the plant at no cost at any time.

Given the embedded option to abandon production the value of your plant is________ $ million. (round to the nearest million)

E) Assume that you are not able to sell the plant, but you are able to shut down the plant at no cost at any time.

The value of the option to abandon production is __________$ million. (round to the nearest million)

F) Assume that it will cost you $1 million to shut down the plant, but you are able to sell the plant for $5 at any time.

What is the value of the option to sell the plant? The value is _________$ million. (round to the nearest million)

Answer 1

Answer:

Current Revenue generated by the company=$2 Million

other costs=$1.6 million

Cost of capital=10%

A) If we are awarded the Government contract & sales increases by 20%,

Total Sales= Present sales+present sales*increment=$2 million+$2 million*20%=$2 million+$0.4 million=$2.4 million

Profit= sales-costs=$2.4 million-$1.6 million=$0.8 million

Value of Plant=Profit/cost of capital=$0.8 million/10%=$8 million

B) If we are not awarded the Government contract & sales decreases by 25%,

Total Sales= Present sales+present sales*increment=$2 million-$2 million*25%=$2 million-$0.5 million=$1.5 million

Profit= sales-costs=$1.5 million-$1.6 million=-$0.1 million=Loss

Value of Plant=Profit/cost of capital=-0.1/10%=-$1 million

=$0=Since value of plant is negative , better we can sell the plant at $5 Million, this becomes the appropriate value.

C) Given the embedded option to sell the plant, equal probability, then value of plant is :

With awarding Government contract, value of plant=$8 million,

Without awarding Government contract, value of plant to sell at =$5 million

Value of Plant=0.5*$8 million+0.5*$ 5 million=$4 million+$2.5 million=$6.5 million

D) Assume that we are not able to sell the plant, but we are able to shutdown the plant at no cost at any time

Given the embedded option to abandon the production, then the value of plant is:

If sales increases, Value of plant=$8 million

If sales decreases, Value of plant=$0 million, (since loss got)

Value of plant=0.5*$8 million+0.5*$0 million=$4 million

E) Assume that we are not able to sell the plant, but we are able to shutdown the plant at no cost at any time,

The value of option to abandon production is:

Value with embedded option=(D)=$4 Millions

Value without embedded option=0.5*$8 million+0.5*-$1=$4 million-$0.5 million=$3.5 million

So, the value of option to abandon the production is=$4 million-$3.5 million=$0.5 million

F) Assume that it will cost $1 million to shut down the plant, but we are able to sell the plant at $5 million,

Then, The value of option to sell the plant:

Value of plant to sell=$5 millions-value of plant without embedded option-shut down cost=$5 millions-$3.5 millions-$1 million=$0.5 million.