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Jimmy's analysts suspect that the Margaritaville Margarita sales will displace 10,000 bottles of the company's existing sales of Wasting Away Whiskey...
Jimmy's analysts suspect that the Margaritaville Margarita sales will displace 10,000 bottles of
the company's existing sales of Wasting Away Whiskey Sours. Each bottle costs $4 to make and
wholesales for $10. Which of the following statements is true?
4. Which one of the following statements is TRUE?
The Margaritaville project's cash flows should be reduced by $24,000.
The Margaritaville project's cash flows should be reduced by $36,000.
The Margaritaville project's cash flows should be reduced by $100,000.
The Margaritaville project's cash flows should be reduced by $60,000.
The Margaritaville project's cash flows should not be adjusted.
Jimmy Buffet, Warren's more famous brother, is considering manufacturing a new, super-tough
flipflop that is both strong enough to survive piercing by small metal objects, thereby
preventing its wearers from cutting their heels, and heat-resistant to protect its wearers from
super-high pavement and sand temperatures. Manufacturing equipment and the initial licenses
for manufacturing cost $200,000. Success of the new product depends crucially on whether
global warming is accelerating (40% probability) or simply increasing at its past rate (60%
probability). If global warming accelerates, then temperatures will be much higher and more
people will live in tropical climates will want the shoes, and cash flows will be $50,000 per year
for 10 years. If global warming continues at its most recent rate, then about the same number
of people will be near beaches and there won't be a need for heat-resistant shoes, and cash
flows will be $20,000 for 10 years. Buffet's cost of capital is 10%.
5. Calculate the project's expected NPV.
6. Calculate the standard deviation of NPV.
Suppose that Buffet can wait a year and find out whether global warming is accelerating or
progressing at the current rate before deciding to invest. If he waits, the initial cost will still be
the same as above (this is known with certainty) and he will know whether the up cash flows
will occur or the down cash flows will occur before deciding whether to invest. The risk-free
rate is 4% and this is the discount rate for the initial investment.
7. Using a decision tree analysis, find the expected NPV of the project if Buffet waits to invest
and only invests if it is optimal to do so.
8. Buffet would like to use a financial option to value the embedded real option. Identify the
value today of the underlying asset. That is, calculate P that would be used in the option pricing