6QQMN566 advanced Corporate Finance

Workshop Questions - Real Options I

Q1.

You are trying to decide whether to make an investment of $500 million in a new technology to produce Everlasting Gobstoppers. There is a 60% chance that the market for these candies will produce profits of $100 million annually, a 20% chance the market will produce profits of $50 million, and a 20% chance that there will be no profits. The size of the market will become clear one year from now. Currently, the cost of capital of the project is 11% per year. There is a 20% chance that the cost of capital will drop to 9% in a year and stay at that level forever, and an 80% chance that it will stay at 11% forever. Movements in the cost of capital are unrelated to the size of the candy market. Assuming you find out the size of the Everlasting Gobstopper market one year after you make the investment. That is, if you do not make the investment, you do not find out the size of the market. Construct the decision tree that shows the choices you have under these circumstances.

Q2.

A professor in the Computer Science department at United States Institute of Technology has just patented a new search engine technology and would like to sell it to you, an interested venture capitalist. The patent has a 17-year life. The technology will take a year to implement (there are no cash flows in the first year) and has an upfront cost of $100 million. You believe this technology will be able to capture 1% of the Internet search market, and currently this market generates profits of $1 billion per year. Over the next five years, the risk-neutral probability that profits will grow at 10% per year is 20% and the risk-neutral probability that profits will grow at 5% per year is 80%. This growth rate will become clear one year from now (after the first year of growth). After five years, profits are expected to decline 2% annually. No profits are expected after the patent runs out. Assume that all risk-free interest rates are constant (regardless of the term) at 10% per year.

(a) Calculate the NPV of undertaking the investment today.

(b) Calculate the NPV of waiting a year to make the investment decision.

(c) What is your optimal investment strategy?

Homework:

Q3.

You are trying to decide whether to make an investment of $500 million in a new technology to produce Everlasting Gobstoppers. There is a 60% chance that the market for these candies will produce profits of $100 million annually, a 20% chance the market will produce profits of $50 million, and a 20% chance that there will be no profits. The size of the market will become clear one year from now. Currently, the cost of capital of the project is 11% per year. There is a 20% chance that the cost of capital will drop to 9% in a year and stay at that level forever, and an 80% chance that it will stay at 11% forever. Movements in the cost of capital are unrelated to the size of the candy market. Construct the decision tree that shows the choices you have to make the investment either today or one year from now.

Q4.

The management of Southern Express Corporation is considering investing 10% of all future earnings in growth. The company has a single growth opportunity that it can take either now or in one period. Although the managers do not know the return on investment with certainty, they know it is equally likely to be either  10% or  14% per year. In one period, they will find out which state will occur. Currently the firm pays out all earnings as a dividend of $10 million; if it does not make the investment, dividends are expected to remain at this level forever. If Southern Express undertakes the investment, the new dividend will reflect the realized return on investment and will grow at the realized rate forever. Assuming the opportunity cost of capital is 10.1%, what is the value of the company just before the current dividend is paid (the cum-dividend value)?

Q5.

You area financial analyst at Global Conglomerate and are considering entering the shoe business. You  believe that you have a very narrow window for entering this market. Because of Christmas demand,  the time is right today and you believe that exactly a year from now would also be a good opportunity.  Other than these two windows, you do not think another opportunity will exist to break into this business. It will cost you $35 million to enter the market. Because other shoe manufacturers exist and arepublic  companies, you can construct a perfectly comparable company. Hence, you have decided to use the  Black-Scholes formula to decide when and if you should enter the shoe business. Your analysis implies  that the current value of an operating shoe company is $40 million and it has a beta of 1. However, the  flow of customers is uncertain, so the value of the company is volatile—your analysis indicates that the  volatility is 25% per year. 15 percent of the value of the company is attributable to the value of the free  cash flows (cash available to you to spend how you wish) expected in the first year. If the one-year risk-  free rate of interest is 4%:

Should Global enter this business and, if so, when?