The real options alternative allows for flexibility and the delay of the investment for 1 year. In this case, if we complete a pilot project we will be better able to evaluate ERP implementation  complexities, achievable supply chain benefits, and the market share our products will achieve. However, the cost of the project will rise to $110 Million ($10 Million this year and $100 Million next year) with the one-year delay and additionally management decides to purchase and implement the financial module in year 1 at a cost of $10 Million (real option).

Year 0 (now) cash flows: $10 million for the pilot project, the financial module. After year 1, if the conditions indicate a good result, the firm will invest the $100 million for the ERP with expected benefits (cash flows) of $15 million annually (forever) beginning in  year 2. Benefits in year one from the financial module are $1 million. If a bad result is indicated, the firm makes no further investments beyond the financial module, which yield annual benefits of $.5 million in year 1 and each year thereafter 
(forever).

Here the firm has flexibility and has exercised its option to make no further investments based on better information and knowledge of expected future benefits.

Evaluate the expected NPV of this project using the described real option. . 

Now we consider that we have the opportunity to do a pilot program by
installing the financial model only at a cost of $10 M.   A year from
now, we can decide whether to invest in the full plant or not.
We can analyze this case as follows:
Good Case ($ M)
Year	0	1
Financial Module	($10.00)
Investment		($100.00)
Year 1 benefit		$1.00
Perpetuity of benefits
Total Cash Flow
PV of Cash Flows
NPV

probability	annual FCF ($ M)
Good Case	75%	$15.00
Bad Case	25%	$2.00
Cost of capital	10.00%

Answer rating: 100% (QA)

To evaluate the expected NPV of the project using the described real option we need to consider the ... View the full answer