Assume you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm’s CEO, George Yamaguchi, recently returned from an in- dustry corporate executive conference in San Francisco, and one of the sessions he attended addressed real op- tions. Because no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm’s executives can use to gain a cursory understanding of the topic.To begin, you gathered some outside materials on the subject and used these materials to draft a list of questions that need to be answered. Now that the ques- tions have been drafted, you must develop the answers.
A. What are some types of real options?
B. What are five possible procedures for analyzinga real option?
C. Tropical Sweets is considering a project that willcost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10%, and the risk-free rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand with associ- ated future cash flows of $45 million per year. There is also a 40% chance of average demand with cash flows of $30 million per year as well as a 30% chance of low demand with cash flows of only $15 million per year. What is the expected NPV?
d. Now suppose this project has an investment timing option, because it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the sce- narios will still last 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option’s value.
e. Use decision-tree analysis to calculate the NPV of the project with the investment timing option. f. Use a financial option pricing model to estimate the value of the investment timing option.
g. Now suppose that the cost of the project is $75 million and the project cannot be delayed. However, if Tropical Sweets implements the proj- ect, then the firm will have a growth option: the opportunity to replicate the original project at the end of its life. What is the total expected NPV ofthe two projects if both are implemented?
h. Tropical Sweets will replicate the original proj- ect only if demand is high. Using decision-tree analysis, estimate the value of the project with the growth option.
i. Use a financial option model to estimate the value of the project with the growth option.
j. What happens to the value of the growth option if the variance of the project’s return is 14.2%? What if it is 50%? How might this explain the high valuations of many start-up high-tech companies that have yet to show positive earnings?