a. Your company is planning on opening an office in Thailand. You are trying to decide whether to open the office now or in 12 months. What type of real option is it a typical example of? What is the economic tradeoff between opening an office immediately and waiting for 12 months?

b. ABC Ltd. considers investing in a research project that produces two types of products: Alpha and Beta. Product Alpha is more innovative and will be produced only if the research is successful. If the research is not successful, the firm can modify the research outcome and will produce Product Beta, which is less innovative. The research is expected to take 3 years to complete. The firm can only tell if the development is a success or failure at the completion of the development. There is only a 25% chance that the research is successful and Product Alpha will be produced. The research costs $3.25 million today.

If the development is successful, Product Alpha will be highly sought after and will earn the firm a net after-tax operating cash flow of $960,000 per annum over the following two years (i.e., year 4 and year 5). At the end of year 5, the firm will have the option to abandon the production depending on the demand for Product Alpha. The management team believes that there is a 60% probability that demand for Product Alpha will be high, and the net after-tax operating cash flow will be $960,000 per annum in perpetuity starting from year 6. However, if the demand is low by the end of year 5, the firm will abandon the production, and it will be able to salvage $120,000 by selling the production in year 5.

If the development fails, Product Beta will be produced and will earn the firm a net after-tax operating cash flow of $480,000 per year for the next two years (i.e., year 4 and year 5). At the end of year 5, the firm will have an option to spend $360,000 to upgrade the production plant. If the demand for Product Beta is high by the end of year 5 (with a 40% probability), the firm will certainly upgrade Product Beta, and the net after-tax operating cash flow will be $960,000 each year in perpetuity starting from year 6. However, if the demand for Product Beta is low by the end of year 5, the firm will not upgrade the production, and the net after-tax operating cash flow will be $480,000 each year in perpetuity starting in year 6.

The company’s cost of capital is 11 percent. What is the net present value of this project? Should the firm undertake this project? Why?
NOTE: Provision of the decision tree is NOT required.

Answer rating: 100% (QA)

a The decision of whether to open an office in Thailand now or in 12 months is a typical example of a real option known as the timing option or delay ... View the full answer