The Bates Pet Motel Company is considering opening a new branch location. If it constructs an office and 100 pet cages at its new location, the initial outlay will be $100,000, and the project is likely to produce net cash flows of $17,000 per year for fifteen years, after which the leasehold on the land expires and the project is left with no residual or salvage value. The company's required rate of return is 18 percent. If the location proves favorable, Bates Pet Motel will be able to expand by another 100 cages at the end of four years. This second-stage expansion would require a $20,000 outlay. With the additional 100 cages installed, incremental net cash flows of $17,000 per year for years 5 through 15 would be expected. The company believes there is a fifty-fifty chance that the location will prove to be a favorable one.
a. Is the initial project acceptable? Why?
b. What is the value of the option to expand? What is the project worth with this option? • Is the project now acceptable? Why?