Problem
You have the opportunity to purchase a facility that manufactures laptops. If you purchase this facility, you expect to sell 5M laptops per year in perpetuity. There is a 50% probability that the profit per laptop will be $80 starting from t=1 onward, and a 50% that the profit per laptop will be $220 starting from t=1 onward. The annual fixed cost of operating the facility is $300M. The purchase price of the facility is $4,000M. Assume a discount rate of 12.5% throughout this question.
I. What is the NPV of the facility at t=0? Make the additional assumption that you have the real option to increase laptop production and thus sell an additional 3M units per year from t=6 onward for a one-time facility upgrade cost of $1,000M at t=5. If you choose to increase laptop production, then the annual fixed cost of operating the facility will increase by $150M from t=6 onward.
II. Suppose that the profit per laptop is $80. What is the NPV at t=5 of increasing laptop production? Will you increase production in this state at t=5?
III. Suppose that the profit per laptop is $220. What is the NPV at t=5 of increasing laptop production? Will you increase production in this state at t=5?
IV. What is the NPV of purchasing the laptop facility at t=0, given that you have the real option to increase production at t=5?