Question 3 Real Options [7points]

AMC Corp. is considering launching a new product but there is some uncertainty about how the product will be received by consumers. Your junior analyst has provided you with three scenarios of possible market conditions and estimated the probability of each scenario. Starting the project today would incur costs of $12,000,000, the cost of capital is 11% and the firm's tax rate is 25%.

The three scenarios are as follows:

"Good": The product is very popular and operating profits are estimated to start at $1,100,000 in year 1 with a 40% annual growth for the following 2 years. Afterwards,growth slows down to 4% forever. The probability of this scenario is 30%.

"Average": Year 1 operating profits are $1,100,000 and grow at 5% in perpetuity. The probability of this scenario is 55%.

"Poor": Year 1 operating profits are $800,000 but decline by 10% each year. The probability of this scenario is 15%.

a) What is the NPV of this project?

b) Suppose AMC can hire consultants to do additional market research to determine how consumers will receive the product. The research will take one year. With this research, AMC know exactly which of the three scenarios is accurate and there would be no uncertainty about the projects outcome before investing at the end of the first year. What is the project's NPVtoday in this case?

c) What is the maximum AMC Corp. would be willing to pay for conducting the additional market research?

d) Without doing any calculations, if the probabilities of the good, average, and poorscenario were 40%, 35%, and 25%instead, respectively, would you expect the value of the option to conduct additional research to be higher, lower, or unchanged? Explain.