Problem Set 5

Advanced Corporate Finance

Due date: November 30
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Problem 1

You are considering a new investment opportunity that lasts two years. The project
characteristics are given in Table 1. In addition to this information, you know that you can
double the capacity of the project after one year by investing another $150m only if the economy
is good (in node B). If you do so, the cash flows in year two will double. The risk free rate is 5%.
Determine the value of the option to expand.

Problem 2

You have the opportunity to invest I = $97 (in millions) in a gold project which (gross) value
will move according to gold prices. In each period, you estimate that gold prices can either move
up by 25% or down by 20%. In a year from now (year 1), the project will have an expected value
(from subsequent cash flows) of $125 (million) if the gold price moves up or $80 (million) if it
moves down. The risk-free interest rate is 2.5%. We are currently in year 0. You have this
project for two years (from year 0 to year 2).

a) What is the static NPV of the project?

b) Suppose that you will have the possibility to postpone the investment decision but if you
do so the capital expenditure increases by 10% every year. What is the optimal
investment strategy? What is the value of the project?

c) Where does the change in value between a) and b) come from?

Problem 3

Your company can undertake an investment project today, next year, or the second year. The
cost of the investment is $100. The expected discounted value of all cash flows generated by this
project is estimated at $95. This value can increase by 25% or decrease by 20%. Based on
historical data you estimate the probability of the project to go up to be 62%. The cost of capital
is 15%. The risk-free rate is 2.5%.

a) Draw the binomial tree depicting the value of the project. What is the NPV of the project
if you invest at t = 0?

b) Compute the value of the option to defer investment, OD

c) Assume that you invest at t=0. At t=1, you have the opportunity to scale up your
investment. You can scale up by 40% by incurring an additional cost of $35. What is the
value of the option to scale up, OE?

d) Assume that you invest at t=0. At t=1, you have the opportunity to scale down your
investment. You can scale down by 50% by selling a part of the project. You estimate the
resale value to be $50. What is the value of the option to scale down, OC?

e) Consider now that the firm has the option to defer investment (until t=1 or t=2) and the
option to expand the scale of operations at t=1 (note that you cannot expand at t=2). What
is the joint value of all options, OJ?

f) Is the sum of the option to defer in part b) and the option to expand in part c) higher or
lower than the value of the options computed jointly in part e)? Explain why the
difference in value occurs.