Great Art Inc is evaluating an investment opportunity in Melbourne that is currently being promoted by Commonwealth government. The project requires initial investment of $4.5 million. If the net cash flow at the end of the first year is $1.5 million (project is successful), the net cash flows will be $2.5 million per annum in perpetuity. The likelihood of the project being successful is 40%. If the net cash flow at the end of first year is $0.8 million (project is unsuccessful) the net cash flows will be $0.5 million per annum in perpetuity. To encourage investment in Melbourne, the Commonwealth government is offering the company the ability to exit the operation at the end of the first year – the government will buy the entire project (assets etc.) for $6 million. The appropriate risk-adjusted discount rate for Great Art Inc is 12.5% per annum.

a) Calculate the net present value for the project with the option. If Great Art Inc took the project (with the option), would it exercise the option at the end of the first year of the project? Why or why not?

b) What is value of the real option that is being offered by the Commonwealth government? Show detailed workings.

Answer rating: 100% (QA)

a Net Present Value NPV of the project with the option can be calculated using the following steps 1 ... View the full answer