You are a division manager evaluating whether to invest in a project that will pay a perpetual stream of cash flows once the assets are fully in place. You are responsible for determining the NPV of the investment and then making a recommendation to the CEO. For this project, you have the choice of either investing today or waiting one year and making your investment choice then. You have no abandonment option—once you choose to invest, you must commit the full cost of the investment with certainty. You have capital in the current period that your CEO, for tax reasons, would like to use today. If your recommendation to her is not to invest today, the capital will be used on other projects. This means that, if you choose to wait one year and then invest, the available capital you will have for the investment is limited. You will, therefore, have to undertake a kind of staged financing strategy if you choose to wait. This financing strategy entails the total upfront cost being split evenly over three years. In other words, you will invest an equal fraction of the upfront cost in three consecutive years if you choose to wait. Regardless of whether you choose to wait, the assets (project) will only begin producing cash flows after they are fully in place (after the entire investment cost has been covered). You expect one of two states of the world to be realized: Up or Down.

You can further assume that it is impossible to switch states from year to year. This means once you are in a state, you remain in that state forever. You have the following additional information:
-The total investment cost is $100 million whether you invest today or wait until next year
-Cash flows once the assets are fully in place are as follows
o Upstate: $12 million in the first year after assets are fully in place, and $20 million per year forever thereafter
o Downstate: $12 million in the first year after assets are fully in place, and $2 million per year forever thereafter

A candidate for a tracking portfolio risky asset is an ETF on the S&P 500 index. It is expected to exhibit the following cash flow realizations for $1 invested today
o Upstate: $1.30
o Downstate: $0.80
 The risk-free rate is expected to be 5% per year forever.

Your CEO prefers your project to others, meaning she would invest today in your project over others. However, she also prefers to use the capital today and hesitates to allow you to “wait and see” whether to invest next year. Given that you will face capital constraints by waiting to invest tomorrow, what recommendation do you make to your CEO? Invest today, or wait and see?

Note: answer must include
1. An analysis of the investment without the option.
2. An analysis of the investment with the option.
3. A computation of the value of the option itself.

Answer rating: 100% (QA)

The investment without the option If the project is undertaken without the option the investment cos... View the full answer