Assume that there is a 50% probability that the annual revenue at the end of the year is $310,000 and 50% probability thet it is $250,000. The revenue is not going to change afterwards. Amber can choose to open the café today or in one year’s time when she is more certain of the annual revenue. If she signs the lease contract today, the annual lease payment is $96,000. If she sign the contract after one year’s time, the annual lease payment is $106,000. Whether she sign the contract now or in one year’s time, the lease contract is for 5 years starting from the day when it is signed, and cannot be terminated before the contract expires. Ignore any possible cash a inflows or outflows after the lease expires.

Assume also that the cost to set up the café is $100,000 and the café is subject to a tax rate of 30%. She will only invest in the café if the net value of the investment over the five year period is higher than $180,000 (ie, NPV>$180,000) at the time of the investment. The appropriate cost of capital is 10% pa. Assume all cash flows occur at the end of the year and before the end of the lease contract.

1. What is the type of the real option as mentioned above? Draw the decision tree diagram to show all possible decisions and scenarios. Denote the decision nodes and information nodes using different shapes, Mark the time as well as the possible scenarios with corresponding decision options. You are required to calculate the NPVs in the next two questions so in the decision tree, you can use notations such as V1 or V2 when necessary.
2. Calculate the NPV of the project at t=0 using after tax cash flows if she opens the safe today.
3. If she decides to open the café one year later, calculate the NPV of the investment respectively at t=1 if the revenue is high and if the revenue is low.
4. Based on your calculation results in (b) and (c), evaluate her choices and make a recommendation. No calculation is needed for this part.
5. Based on the specifics of the café in the question give an example of an abandonment option and describe how it may affect her decision.

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The real option as mentioned above is an option to delay Amber has the option to delay the investmen... View the full answer