Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10%, and the risk-free rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand, with future cash flows of $45 million per year. There is a 40% chance of average demand, with cash flows of $30 million per year. If demand is low (a 30% chance), cash flows will be only $15 million per year. What is the expected NPV?

Assume you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm’s CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options. Because no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm’s executives can use to gain at least a cursory understanding of the topic.

To begin, you gathered some outside materials on the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.