Initial investment in a project cost $152 million and has a discount rate/risk-free rate of 7% per year. The expected cash flows starting with year 1 is $11 million and continuing forever. However, these are based on a 23% chance of earning $5 million per year, a 23% chance of earning $10 million per year, a 23% chance of earning $12 million per year, and a 23% chance of earning $ 15 million per year.

Increasing the cash flow by 32% for 2 years and forever can increase the project's performance in the first year. However, the cost of investment depends on the market performance. If the market perform slightly poor (your cash flows are $8 million), improving quality control will cost $42 million. If the market performs bad (your cash flow is $5 million), improving quality control will cost $36 million. If the market is good (cash flows are $15 million), improving quality control will cost $76 million. If the market is slightly good (cash flows are $13 million), improving quality control will cost $ 46 million. Each of these costs will be paid in one time.

Determine the NPV (at time 0) of exercising the option at time 1 in the bad (cash flow = $5 million) case, based on whether or not you will exercise the option in the case.

Answer rating: 100% (QA)

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