Use simple decision trees and a 10% per year discount rate to evaluate Project Sable, which has two phases. You may invest in the first, in both or in neither. You may not invest in the second phase without investing in the first. Phase 1 requires an investment of $100. One year later the project delivers either $160 or $60 with equal probability. At that time, after the phase 1 payout has been received, you may invest an additional $100 for phase 2. One year later, phase 2 pays out either 20% more cash than phase 1 actually delivered or (equally likely) 20% less. Assume no taxes.
a. How much would Project Sable be worth if it offered only the phase 1 opportunity?
b. How much would phase 2 be worth if you had to choose today, once and for all, whether or not to invest in it?
c. How much is Project Sable worth if you have access to both phases and can wait to decide whether to invest in phase 2?
d. How would you allocate the value of Project Sable between assets-in-place and real options?
e. Assuming that investment in Project Sable will require external funding, what dollar amounts of debt and equity do you recommend (assume capital markets are informed and efficient, and that the risk-free rate of interest is 5%)?