Reference no: EM132497128

Pouteau Steel is evaluating a proposal to invest $200 million to expand production capacity at their Heavener, Oklahoma mill. If the firm invests to expand capacity immediately at date 0 the mill will generate incremental after-tax cash inflows of $20 million at the end of the year, at date 1. The end-of-the-year continuation value of the proposed expansion will be $300 million if the economy is experiencing strong economic growth at date 1, but only $150 million if the economy deteriorates. If Poteau Steel waits until the end of the year (date 1) to invest in the proposed expansion, the incremental date 1 after-tax cash flow of $20 million will be lost. However, the date 1 continuation value of the expansion will be known with certainty.

Quetsion 1: The cost of expansion is expected to remain constant. Assuming that the risk-free interest rate is 1.5 percent and the risk-adjusted probability that the economy will have strong economic growth is 0.35, determine whether Poteau Steel should invest today, or wait until date 1 to re-assess the desirability of the expansion.