Cherone Equipment, a manufacturer of electronic fitness equipment, wishes to evaluate two alternative plans for increasing its production capacity to meet the rapidly growing demand for its key product-the Cardiocycle. After months of investigation and analysis, the firm has pruned the list of alternatives down to the following two plans, either of which would allow it to meet its forecast product demand.
Plan X: Use current proven technology to expand the existing plant and semiautomated production line. This plan is viewed as only slightly more risky than the firm's current average level of risk.
Plan Y: Install new, just-developed automatic production equipment is the existing plant to replace the current semiautomated production line. Because this plan eliminates the need to expand the plant, it is less expensive than Plan X, but it is believed to be far more risky because of the unproven nature of the technology.
Cherone, which routinely used NPV to evaluate capital budgeting, projects, has a cost of capital of 12%. Currently the risk-free rate of interest, RF, is 9%. The firm has decided to evaluate the two plans over a 5 year time period, at the end of which each plan would be liquidated. The relevant cash flows associated with each plan are summarized in the following table.
Plan X Plan Y
Initial investment (CF0) $2,700,000 $2,100,000
Year (t) Cash inflows (CFt)
1 $470,000 $380,000
2 $610,000 $700,000
3 $950,000 $800,000
4 $970,000 $600,000
5 $1,500,000 $1,200,000
The firm has determined the risk-adjusted discount rate (RADR) applicable to each plan as shown in the following table:
Plan Risk-adjusted discount rate (RADR)
X 13%
Y 15%
Further analysis of the two plans has disclosed that each has a real option embedded within its cash flows.
Plan X Real Option - At the end of 3 years the firm could abandon this plan and install the automatic equipment, which by then would have a proven track record. This abandonment option is expected to add $100,000 of NPV and has a 25% chance of being exercised.
Plan Y Real Option - Because plan Y does not require current expansion of the plant, it creates an improved opportunity for future plant expansion. This option allows the firm to grow its business into related areas more easily if business and economic conditions continue to improve. This growth option is estimated to be worth $500,000 of NPV and has a 20% chance of being exercised.