A company is deciding on whether to fund the following project. There are two possible market outcomes: “good” or “bad” –If the market state is good, the project value is estimated to be 8,000 Millions. – If the market state is bad, the project value is estimated to be 3,000 Millions. The market outcome will be known at the end of the first year. The objective probability of the good market state is 0.30. The project’s initial capital investment I0 is 4,000 Millions. Risk free rate is 5%. The appropriate risk-adjusted cost of capital is 25%
Required
What is the project value (after investment?)
What is the project’s NPV
Upon further review, the CFO realizes it does have the following options: If the market outcome is good, the company can expand operations with an additional capital expenditure of 1,000 Millions. Expansion will increase the project’s value by 50%. If the market outcome is bad, the company can liquidate its capital investment for 50% of its original value.
Required
What are the values of the project with flexibility given the state-contingent optimal action?
What are the values of the project with flexibility (after investment) and the project’s NPV using traditional analysis?
Is the original cost of capital appropriate given the riskiness of the values for the project with flexibility?
What are the state equations and what is the replicating portfolio
What is the cost of the replicating portfolio? What is the ROA value of the project with flexibility?
What is the value (after investment) of the project with flexibility using risk-neutral pricing?