The Z-90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another one of its products, Z-45, becomes an industry standard. There is a 60% chance that the Z-45 will become the industry standard, in which case the Z-90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 40% chance that the Z-45 will not become the industry standard, in which case the Z-90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%. Now assume that the compnay cannont wait to implement the original project and has to move on with it today for the fear of advancing competitiors that may otherwise impose their own industry standard. Therefore, an option to wait is no longer available. Instead:
a) Assume that at the end of the first run of Z-90 project, SI will ahve an opprunity to return it, if the Z-45 has become the industry standard, and will only reinvest in that case. The cash flows will be the same and will still be available for extra 5 years from the second investment. Assuming that the cost of capital remains at 12%, what is the estimated value of this growth option? What is the coefficient of variation of the projects cash flows with the option to wait? Is the overall risk of the project reduced with the introduction of the option (Yes/No)?
b) Using Black and Scholes option pricing model,find the Value (V) of this growth option using N(d1)=0.5368 and N(d2)=0.3465. Risk free rate is 6%.
- Identify and/or find all the inputs. SHow work for P calculation.
- What is the total value of the project with the option to grow?