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NPV & Real Options

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The cash flows are $8.5 million at the end of year 1, end of year 2, etc., "forever".

An ordinary perpetuity assumes payment at the end of the year, so the $85 million does not need further discounting -- we're evaluating everything as of "today".

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NPV and Real Option Approach

Refer to the attached Practice Problem I.

The assignment is to evaluate both parts, the traditional NPV calculation as well as the Real Options approach. The probability of a successful project (or pilot) is now .65 (instead of .5) and the probability of an unsuccessful project is .35 (instead of .5).

What is the expected NPV in each case now? What do you recommend? Why?

If you don't know the probability of success for the pilot, is there a value that is critical to your recommendation? Is there a probability of success above or below which you will recommend undertaking the pilot and below or above which you will recommend a go/ no go decision on the underlying project without undertaking a pilot test?

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