Real option to expand that is embedded in initial project

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Reference no: EM131569883

Growth Option Grumble Ltd is all equity funded (no debt) with a beta of 1.8. The company is considering a new project, which involves an initial phase to test the viability for a new business followed by a major expansion if viability can be shown. The initial phase will cost $55 million and is expected to provide annual cash inflows of $11 million per year. A time limit of 5 years has been put on the initial phase of the project, at the end of which it will be either dropped if it is not viable or expanded if it is proved to be viable. If the expansion is undertaken, then the further investment expected in 5 years from now is $250 million. Expected cash flows from the expansion phase have a present value of $200 million (in t=0 values), but the cash flows are subject to an annual standard deviation of 30%. The risk free rate 3% (continuously compounding). The market risk premium is 6% p.a. (a) Calculate the net present value of the initial phase of the project, ignoring the option to expand. (b) Calculate the value of the real option to expand that is embedded in the initial project?

Reference no: EM131569883

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