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Expected future cash flows from the project

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Ambev is considering introducing a soft drink to the U.S. market. The drink will initially be introduced only in the metropolitan areas of the U.S. and the cost of this "limited introduction" is $500 million.

A financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to Ambev will be only $400 million.

If the initial introduction works out well, Ambev could go ahead with a full-scale introduction to the entire market with an additional investment of $1 billion any time over the next 5 years. While the current expectation is that the cash flows from having this investment is only $750 million, there remains considerable uncertainty about the sales potential of the drink, leading to significant variance in this estimate.

(a) What is the NPV of the project ("limited introduction") today based on the expected future cash flows from the project?

(b) What is the real option that Ambev has in this situation? Can we describe the situation by making an analogy with a financial option (call option or put option)? Identify the value of the underlying asset, the exercise price, and the expiration date of the financial option.

(c) Suppose that you estimated the value of the financial option to be $234 million on the basis of a financial option pricing technique. Should Ambev invest in the project, that is, invest in the "limited introduction" of the soft drink today?

Reference no: EM132535289

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