QUESTION ONE (20 MARKS)

A company operates under hard budget constraints and has a WACC of 12%. In the current year it can spend a maximum of Kshs. 80 million on a new investment. The management is considering two alternative projects: Project 1 and Project 2, each of the two projects would run for two years and be sold at a fair price. Both of the projects require Kshs. 80 million initial investments and have present values without flexibility equal to Kshs. 100 million. However project 1 has an annual volatility of 40% and project 2 has an annual volatility of 20%. Both projects allow the management to contract operations by 40% and at any time during the next two years. With project 1 the cash received from contracting would be Kshs. 33 million and with project 2 it would be Kshs. 42 million. The risk free rate is 5%. Using a decision tree analysis (DTA) answer the following questions:

(a)Which project should the company selects, and what other factors should be considered while making the decision?(10 Marks)

(b)When and under what conditions would the option to contract be executed with each project?(5 Marks)

(c)What is the value of option to contract with project1 and with Project 2

(5 Marks)