Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 million per year for three years. The cost of capital for this type of project is 10 percent and the risk-free rate is 6 percent. After discussions with the marketing department, you learn that there is a 30 percent chance of high demand, with future cash flows of $45 million per year. There is a 40 percent chance of average demand, with cash flows of $30 million per year. If demand is low (a 30 percent chance), cash flows will be only $15 million per year.
We further assume that this project has an investment timing option, since it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the scenarios will still last three years. However, Tropical Sweets will know the level of demand, and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option's value.
Please complete the following three questions based on the case provided:
Questions1: What is the expected NPV?
Question 2: Do you think the project should be taken or rejected?
Question3: Should this project wait for another year or start now? (Note: Three scenarios of NPV should be calculated in order to provide the solid recommendation).
Excel file contains qualitative assessment of the investment timing option's value.