Question

CherryBerry is considering opening a location on the east side of Mexico City. The firm is uncertain about the success of the venture due to uncertainty about demand for its frozen yogurt products in Mexico. Opening the store would require an initial investment of $500,000. The firm estimates that there is a 60% chance that the store will be successful and generate cash flows of $200,000 per year, forever. There is a 40% chance that the store will be a failure and generate cash flows of only $50,000 per year, forever. If the store is successful, this would open the door to an opportunity to open another CherryBerry location on the west side of Mexico City. This second location would require an investment of $500,000, which would occur one year after the start of the first store (i.e., Year 1). If the first store is successful, this second store would also be successful and generate cash flows of $200,000 per year, forever. Given the risk of this venture, CherryBerry estimates that a discount rate of 20% is appropriate.

1.What is the NPV of the project, ignoring the embedded expansion option? Round your final answer to the nearest dollar.

a.125,000 b.-125,000 c.200,000 d.175,000 e.450,000

2.What is the value of the embedded expansion option? Round your final answer to the nearest dollar.

a.250,000 b.208,333 c. 200,000 d.100,000 e.150,000

Answer 1

1.)

opening a location on the east side of Mexico City
If the project is success will generate $ 200000 PA
Its probability = 0.6
If it is failure, Annual Cash flow will be $50000
Its probability = 0.4
so the expected value cash flow=(200000 x 0.6)+(5000 x 0.4)			140000
Discount rate			20%
Here the cash flow is for ever, i.e. perpetuity, under perpetuity, PV = Cashflow / Disc.rate = $s					700,000
Initial investment in $s					500,000
Nat Present Value in $S					200,000

Answer is option c. 200,000

2.) the value of the embedded expansion option is a. 250,000

if the 1st project is success, they will start another project on the west side of Mexico City
Annual csh flow will be $ 200,000 PA
Discount rate			20%
Here the cash flow is for ever, i.e. perpetuity, under perpetuity, PV = Cashflow / Disc.rate = $s		1000000
Cost of this project in $s		500000
Nat Present Value in $S		500000
But the project will start after 1year
then NPV is to be discounted, =500000/1.2		416666.6667

Additional NPV 416667. probability for success of first project = 0.6, only if first project is succes, then only go with 2nd project so the value of expansion =Additional NPV on Expansion x probability =416666.67 x 0.6 = 250,000