Answer the following question based on the example in section 9.2.1 in the online lecture.

If we have to decide now in 2014, once and for all, whether to invest in S-II, should we accept it or not? Explain briefly.

9.2.1. Follow-on Investment Options

To understand the concept of follow-on investment options, let's take the following example.

Example: Follow-on Investment Options

Suppose you have a project to develop a new type of smartphone in 2014. The name of the new type of smartphone is Model S-I. You calculate the net present value of the project based on the estimated cash flows. It turns out to be $-46 million.

NPV₂₀₁₄(Model S-I) = -450 + 404 = $-46 million

Therefore, this project is not acceptable. However, if we go ahead, we have the opportunity to make follow-on investments which could be very profitable. The Model S-I gives not only its cash flows but also a call option to go on with Model S-II. This call option is the real source of strategic value.

The decision to invest in Model S-II must be made 3 years after, i.e., in 2017. The required investment for Model S-II in 2017 is expected to be $900 million; and the expected PV of subsequent cash flows from Model S-II in 2017 is $800 million.

Thus, NPV₂₀₁₇(Model S-II) = -900 + 800 = $-100 million.

In other words, Model S-II is about twice as bad as Model S-I. Its NPV = $-100 million when S-I's NPV = -$46. But there is a chance that S-II could be extremely valuable.

Calculate the value of the embedded follow-on investment option using the B-S option-pricing model. Assume (CF of S-II) = 35%; r_Firm = 20%; r_f = 10%.

To calculate the value of the call option we need to know the following five values: S, X, T, r_f, . The asset value (S) in 2014 is calculated as 800/(1.2)³ = $463 million. Then, we can calculate the value of the call option, using the B-S formula, as C = $55.12.

Then, the NPV (S-I) = -46 + 55.12 = $9.12 million and the project is acceptable because of the follow-on investment opportunities embedded in it.

There are several types of follow-on investment options. One lets a company increase the capacity of an existing product line. The second type of growth option allows a company to expand into new geographical markets. The third type of growth option is the opportunity to add new products, including complementary products and successive "generations" of the original product. The above example of Model M-II is an example of the third type.