Your company wants to invest in a new product. The marketing department provided you with the following data:
After-tax cash flows for new product
Year 1 2 3 4 5 6
Low Demand 100 100 100 100 100 100
High Demand 300 500 600 700 700 600
All the cash flows will be received at the end of the year (Ignore taxes and depreciation). The project will require an initial investment today of $1,200.
A. Standard NPV: Assume that there is a 50% chance of high demand and a 50% chance of low demand. Compute NPV if the project is carried through to the end of Year 6 regardless of the demand. The appropriate discount rate is 11%.
B. Real Options NPV: Using the information above, if the demand is low your company can abandon the project at the end of the first year and sell the equipment for $550 (includes all tax ramifications of the sale). Use the 11% discount rate to compute the NPV including the option to abandon the project if demand is low.
The solution explains the concept of Real options really well using the example in the question. The solution is really easy to follow for anyone who has a basic understanding of finance. All the steps are clearly shown. Overall, an excellent response.