Real Options

A tax sheltered firm (0% corporate tax rate) operating from the Six Nations Reserve is considering investing in a newly identified market opportunity. While initial estimates look promising, there is a great deal of uncertainty about how the product will actually be received by consumers. To help in your analysis, your assistant has provided you with three sets of market conditions and estimated the probability of each set of circumstances (we know in year 1 what will happen from that point forward). Starting the project today would incur costs of $20,000,000 and the cost of capital would be 10%.

"Good": The product is very well received and profits are estimated to start at $1,500,000 in year 1 with 40% annual growth for 2 years and then slowing to 4% growth into the foreseeable future (at least 30 years). The probability of this occurring is estimated to be 30%.

"Average": Profits start at $1,200,000 in year 1 and grow continuously at 5% for the foreseeable future. Probability of occurring is 50%

"Poor": Profits start at $800,000 in year 1 but then drop off by 10% each year into the future. Probability of occurring is 20%.

a) What is the NPV of this project?

b) What would the present value of the project be if you opted to wait until year 2 so that there would be no uncertainty about the project's outcome?

c) Your analyst is concerned about the logic used in part b and argues that waiting two years would allow other competitors to seize a first mover advantage such that the first year of profits would be 80% of those initially projected under any circumstance AND the probability of a "good" outcome drops to 20% (probability of average becomes 60%, "bad" probability stays at 20%). Should you wait to invest or not?

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