Complete the Chapter 14 Mini Case (page 568). MINI CASE: TheAssume you have just

Question

Complete the Chapter 14 Mini Case (page 568).

MINI CASE:

TheAssume you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended addressed real options. Because no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives can use to gain at least a cursory understanding of the topic.

To begin, you gathered some outside materials on the subject and used these materials to draft a list of pertinent questions that need to be answered. Now that the questions have been drafted, you must develop the answers.

Chapter 14 Mini-Case is below:

a. What are some types of real options?

b. What are five possible procedures for analyzing a real option?

c. Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10%, and the riskfree rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand with associated future cash flows of $45 million per year. There is also a 40% chance of average demand with cash flows of $30 million per year as well as a 30% chance of low demand with cash flows of only $15 million per year. What is the expected NPV?

d. Now suppose this project has an investment timing option, since it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the scenarios will still last 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option's value.

e. Use decision-tree analysis to calculate the NPV of the project with the investment timing option.

f. Use a financial option pricing model to estimate the value of the investment timing option.

g. Now suppose that the cost of the project is $75 million and the project cannot be delayed. However, if Tropical Sweets implements the project then the firm will have a growth option: the opportunity to replicate the original project at the end of its life. What is the total expected NPV of the two projects if both are implemented?

h. Tropical Sweets will replicate the original project only if demand is high. Using decision-tree analysis, estimate the value of the project with the growth option.

i. Use a financial option model to estimate the value of the project with the growth option.

j. What happens to the value of the growth option if the variance of the project's return is 14.2%? What if it is 50%? How might this explain the high valuations of many start-up high-tech companies that have yet to show positive earnings?

I require this particular assignment ASP! Complete as possible!!

Explanation / Answer

Answer:a

1.Investment timing options

2.Growth options

a.Expansion of existing product line

b. New products

c.New geographic markets

3. Abandonment options

a.Contraction

b.Temporary suspension

c.Complete abandonment

4. Flexibility options.

Answer:b

1.DCF analysis of expected cash flows, ignoring option.

2. Qualitatively assess the value of the real option.

3. Decision tree analysis.

4. Use a model for a corresponding financial option, if possible.

5. Use financial engineering techniques if a corresponding financial option is not available.

Answer:c Initial Cost = $70 Million

Expected Cash Flows = $30 Million Per Year For Three Years

Cost Of Capital = 10%

PV Of Expected CFs = ($30 million*PVIFA(10%,3))=$74.61 Million

Expected NPV = $74.61 - $70

= $4.61 Million

Answer:d If we immediately proceed with the project, its expected NPV is $4.61 million. However, the project is very risky. If demand is high, NPV will be $41.91 million. If demand is average, NPV will be $4.61 million. If demand is low, NPV will be -$32.70 million. However, if we wait one year, we will find out additional information regarding demand. If demand is low, we won’t implement project. If we wait, the up-front cost and cash flows will stay the same, except they will be shifted ahead by a year.

The value of any real option increases if the underlying project is very risky or if there is a long time before you must exercise the option.

This project is risky and has one year before we must decide, so the option to wait is probably valuable.

Answer:e The project will be implemented only if demand is average or high.

Here is the time line:

0                             1            2            3          4

      High                     $0      -$70        $45      $45        $45

      Average                $0      -$70        $30      $30        $30

      Low                      $0          $0          $0        $0          $0

To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is known for certain, and discount the other risky cash flows at the 10 percent cost of capital.

High: NPV = -$70/1.06 + $45/1.102+ $45/1.103+$45/1.104= $35.70

Average: NPV = -$70/1.06 + $30/1.102 + $30/1.103 +$30/1.104 = $1.79

Low: NPV = $0.

Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42.

Since this is much greater than the NPV of immediate implementation (which is $4.61 million) we should wait. In other words, implementing immediately gives an expected NPV of $4.61 million, but implementing immediately means we give up the option to wait, which is worth $11.42 million.

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