13-2 ANALYZING A STRATEGY USING OPTION ANALYSIS Reliable Industries is consideri

Question

13-2 ANALYZING A STRATEGY USING OPTION ANALYSIS Reliable Industries is considering the construction of a power plant investment in India. Reliable’s analysts calculate that the cost of building the plant is $600 million, and the internal rate of return (IRR) of the plant is 13%. The analysts also estimate that, given the experience of building the first plant, a second plant can be built for $550 million, and additional plants can be built for about $500 million each. The cost of capital is 16%. a. How would you evaluate whether or not to build this power plant in India? b. Are you evaluating a project or a strategy? c. How does the risk associated with the power plant strategy compare with the risk associated with the individual power plants?

Explanation / Answer

As the Internal Rate of return is less than the cost of capital, the plant should not be built in India. The required return must be greater than the cost of capital. It will give the net Cash Flows Negative. We are evaluating a strategy as there are a no of power plants.

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