Question

1.

1. You are a financial analyst at HE PLC and are evaluating a set of risky investment project, some features of which are noted below:

Project ID	Investment Outlay	Present Value of Future Cash Flows
A	1400	1875
B	2250	2800
C	2100	1800
D	3250	4425
E	4200	5500

The investment outlay and present value of the future cash flows are in millions. There is a limited budget of £6,250 million, such that all the projects cannot be chosen for investment and if need be, you can invest in fractions of a project. With supporting calculations, make your recommendation on the portfolio of projects that maximises the net present value for the company.

2. You own a small manufacturing operation that currently generates revenues of £2 million per year. Next year, based upon a pending decision by the government whether to award you a long-term government contract, your revenues will either increase by 30% or decrease by 25%, with equal probability, and stay at that level as long as you continue operations. Running costs are £1.6 million per year. Your cost of capital is 10% per annum.

If you can sell the plant at any time to a large conglomerate for £5 million. What is the value of your company today?

3. Discuss the role of real options in the valuation of a company.

Answer 1

a.

Project ID	Intial Payoff	PV of cashflow	NPV/Investment	Rank on investment Preferences	Capital Investment
A	1400	1875	33.9%	2	1400
B	2250	2800	24.4%	4	0
C	2100	1800	-14.3%	5	0
D	3250	4425	36.2%	1	3250
E	4200	5500	31.0%	3	1600

As per the above calculation project D is most preferable project followed by A,E,B & C.

So, First 3250 should go to D and 1400 to A and remaining 1600 should go to E.

The portfolio would be = D+A+1600/4200E or D+A+0.38E

b) Next year the expected return of the company= 0.5*2*(1+30%)+0.5*2*(1-25%)=£2.05mn

Expected net profit= £(2.05-1.6)=£0.45

So, as per gordon's DDM model value of all future cash flow= 0.45*(1+0%)/(10%-0%)=£4.5

So, total value of the firm=salvage value+4.5=5+4.5=£9.5mn

c)  Real Option maker has the right but not obligation for making strategic decision to start/abandon/initiate/staging etc. a new project. If the new project brings high value to firm, the value of the firm might go to high and vice versa.

So, role of real option is very important in the valuation of company.