A new 12-year project has estimated sales of 7,500 units per year, an end-of-year net cash flow of $65 per unit, a discount rate of 15.5 percent, and an initial cost of $2.5 million. Sales will be revised upward to 8,200 units if the first year is a success and revised downward to 5,000 units if the first year is not a success. Suppose the scale of the project can be doubled in one year thereby increasing the sales projected to 16,800 units. Naturally, expansion would be desirable only if the project is a success. The project could also be dismantled after the first year and sold for $1,900,000. Assume that success and failure are equally likely. What is the current value of the option to expand?

Question

Quizplus · Accepted Answer

The current value of the option to expand takes into account the potential increase in value from expanding the project if the first year is successful. Given the complexity of the calculation, which involves estimating the expected cash flows from the expanded project, discounting those cash flows back to the present value at the given discount rate, and considering the probability of success, the correct answer reflects an advanced financial analysis. The option to expand adds value to the project by allowing for increased sales and cash flows if the initial phase is successful, which is captured in the valuation of option B.

A New 12-Year Project Has Estimated Sales of 7,500 Units