Hatch Corporation is thinking of building a Survivor Camp far out in the corn fields outside of Chicago. Similar camps already exist around the US. The investment will cost $250M and cash flow will start arriving one year after the investment. Because of the violent and dangerous nature of such camps, the CEO of Hatch Corporation estimates that there is a probability p = 0.1 of the industry being subject to a lawsuit this year. The lawsuit is equally likely to be successful and to be dismissed. In case the lawsuit is successful, all such camps will be banned and cash flows will be 0 forever. If the lawsuit is dismissed, the extra attention created will increase demand and cash flows are expected to go up to $100M per year forever. If there is no lawsuit at all this year, the cash flows are expected to be $50M forever.
a) Assuming the CEO decides to invest today, what is the NPV of the project?
b) Now assume that the CEO decides to wait until year 1 to make the investment. (Of course, cash flows will not start arriving until in year 2 then.) Assume that the CEO can make the investment decision after observing whether there was a lawsuit or not and the outcome of the lawsuit. What is the NPV (as of year 0) of this strategy? Is he better or worse off than when he invested at 0? Explain the intuition.
c) Now assume the risk of the lawsuit is p=0.3 instead of 0.1. Does this change your answer to question b)? Explain the intuition (and do the numbers, of course).
d) Now assume that the investment is reversible, meaning that you will be able to get your $250M investment back in any of the three scenarios by selling the land and the equipment if you so choose (of course, you would miss out on the later revenues then). Assume p=0.3 as in c). How will this affect the timing of your investment? Explain the intuition.