A company operates under a hard budget constraint and has a WACC of 12%. In the current year it can spend a maximum of $80 million on a new investment. The management is considering two alternative projects: project 1 and project 2. Each of the two projects would run for two years and be sold at a fair price. Both of the projects require an $80 million initial investment and have present values without flexibility equal to $ 100 million. However, project 1 has an annual volatility of 40%, and project 2 has an annual volatility of 20%. Both projects allow the management to contract operations by 40% at auy time during the next two years. With project 1 the cash received from contracting would be $33 million, and with project 2 it would be $42 million. The risk-free rate is 5%.
(a) Using a decision tree analysis (DTA), answer the following questions: Which project should the company select? When and under what conditions would the options to contract be executed with each project? What is the value of the option to contract With project 1 ? What is the value of the option to contract with project 2?
(b) Using real option analysis (ROA), answer the following questions: Which project should the company select? When and under what conditions would the options to contract be executed with each project? What is the value of the option to contract with project 1? What is the value of the option to contract with project 2?
(c) Do the DTA and ROA valuation results suggest the same optimal execution for the options? Do the DTA and ROA valuations show the same value for each of the two projects? Do the DTA and ROA valuations select the same project as a winner?