Reference no: EM132548137

The famous American hamburger chain Fat and Spicy (F&S) is considering expanding its operations to Australia. F&S is considering opening a restaurant in two locations, one each in Sydney and Melbourne. F&S estimates the following (the same estimation for each of the two locations):

• Initial investment $1,000,000 per restaurant
• FCF if the demand is high $150,000 in perpetuity per restaurant
• FCF if the demand is low $70,000 in perpetuity per restaurant
• Probability of high demand 50%
• Opportunity cost of capital 10%
• If the demand is high in Sydney it will also be high in Melbourne; and if the demand is low in Sydney it will also be low in Melbourne.
• If the demand is high (low) in the first year it will be high (low) in perpetuity

a) The company decided to invest first in Sydney and depending on the success of the restaurant in Sydney will decide whether to invest in Melbourne. What type of real option has the company decided to invest in?

b) Calculate the value of this real option.

c) One of the directors asked you to calculate the value of the real option using risk neutral probabilities. What can you say about the risk neutral probability in this project?

d) Assume now that there is no correlation between high demand in Sydney and high demand in Melbourne. What will the optimal investment policy of the firm be? Explain. What will the value of the real option be?

e) One of the directors in the company suggested that because of the rivalry between Sydney and Melbourne there will be a negative correlation between the success in Sydney and Melbourne (that is if there is high demand in Sydney there will be low demand in Melbourne, and vice versa).

If the director is right what will be the best investment policy? Will the value of the growth option will be higher or lower than the one you calculated in part (d)? No calculations are needed.