Page 168 - AFM Integrated Workbook STUDENT S18-J19

Chapter 8

Illustration 2

Hoop Co has been appraising a new investment project. The project requires
an initial investment of $3 million, but the present value of its future cash flows
is only expected to be $2.8 million. Therefore, because of the negative NPV of
$0.2 million, the directors are considering rejecting the project.

However, the marketing director is keen to undertake the project for strategic
reasons. She feels that undertaking this project will create a “follow-on option”,
to invest $2 million into another project in three years’ time. She has asked the
finance director to perform some further analysis before a final decision is
made.

The finance director has forecast that the present value of the cash flows
generated by the new project (not including the initial investment) is likely to be
$1.8 million, and that the volatility associated with the cash flows is 25%.

The risk free rate of interest is 5%.

Required:

Calculate the value of the follow-on option, and advise the directors
whether the project should be undertaken.

Solution

The five input factors for the BSOP model are:

P a = 1.8 (million)

P e = 2 (million)

r = 0.05

s = 0.25

t = 3 (years)

2
ln 1.8 + 0.05 + 0.5 × 0.25 ×3
2
d =
1
0.25√3
= 0.3196 (so 0.32 to 2 decimal places)

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