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Problem #1 Your company manufactures commercial cleaning equipment.You have the capacity to produce computer operated floor scrubbers. For this...
Problem #1
Your company manufactures commercial cleaning equipment. You have the capacity to produce computer operated floor scrubbers. For this product line, model #1 will be produced for 10 years. However, if cash flows are higher than expected, model #2 will be introduced in the middle of year 3. If cash flows are higher than expected, model #3 will be introduced in the middle of year 5. You are being asked today to evaluate the proposal for creating the computer operated scrubbers. For both models 2 and 3, the introduction of the new product line will be a few months after the decision has been made. The hurdle return is 10% and the risk free rate is 5%.
You have the following information for Model #1:
The initial investment for model #1 is $10 million. Present value0 today of 10 years of free cash flows is $22.7 million.
Information for Model #2:
The decision to introduce model #2 and terminate production of model #1 will be made at the start of year 3 using the cash flows from the first two years for model #1. The present value at start of year 3 is the sum of cash flows for next 7 years, netting cash flows no longer received from model #1 (cannibalized). PV3is $46 million. There is uncertainty about the forecasted cash flow which may be 20% higher. The initial expenditure for production of model 2 will be made at the start of year 3 and is known with certainty and is $40 million.
Information for Model #3
The decision to introduction of model #3 and terminate production of model #2 will be made at the start of year 5 using the first two years cash flows for model #2. The present value at start of year 5 is the sum of cash flows for next 5 years, netting cash flows no longer received from model #2 (cannibalized). PV5is $71 million. There is uncertainty about the forecasted cash flow which may be 25% higher. The initial expenditure for production of model 3 will be made at the start of year 5 and is known with certainty and is $72 million.
1. Draw the decision tree for the problem with labels.
2. How much is the NPV of Model 1 alone?
3. Using the Black and Scholes excel, calculate value at year 3 of the call option to introduce Model 3.
4. How much is the market value of Model #2 with option to introduce Model #3?
5. Using the Black and Scholes excel calculate value the nested call option to introduce Model 2 with the possibility of replacing Model #2 with Model #3.
6. How much is the net present value of model 1 with the option to replace Model #1 with Model #2 and the further possibility of replacing model #2 with Model #3?
