Jimmy Buffet, Warren's more famous brother, is considering manufacturing a new, super-tough flipflop that is both strong enough to survive piercing by small metal objects, thereby preventing its wearers from cutting their heels, and heat-resistant to protect its wearers from super-high pavement and sand temperatures. Manufacturing equipment and the initial licenses for manufacturing cost $200,000. Success of the new product depends crucially on whether global warming is accelerating (40% probability) or simply increasing at its past rate (60% probability). If global warming accelerates, then temperatures will be much higher and more people will live in tropical climates will want the shoes, and cash flows will be $50,000 per year for 10 years. If global warming continues at its most recent rate, then about the same number of people will be near beaches and there won't be a need for heat-resistant shoes, and cash flows will be $20,000 for 10 years. Buffet's cost of capital is 10%
Suppose that Buffet can wait a year and find out whether global warming is accelerating or progressing at the current rate before deciding to invest. If he waits, the initial cost will still be the same as above (this is known with certainty) and he will know whether the up cash flows will occur or the down cash flows will occur before deciding whether to invest. The risk-free rate is 4% and this is the discount rate for the initial investment.
1. Using a decision tree analysis, find the expected NPV of the project if Buffet waits to invest and only invests if it is optimal to do so.
a. 26,143
b. 28,757
c. 31,633
d. 34,796
e. 38,276
2. Buffet would like to use a financial option to value the embedded real option. Identify the value today of the underlying asset. That is, calculate P that would be used in the option pricing model.
a. 162,132
b. 170,239
c. 178,751
d. 187,689
e. 197,073