Real Options

Vortex Inc. is considering launching a new product but there is some uncertainty about how the product will actually be received. Accordingly, your junior analyst 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 $12,000,000, the appropriate cost of capital is 11% and the firm's tax rate is 25%. Ignore salvage and depreciation.

? "Good": The product is very well received and operating profits are estimated to start at $1,100,000 in year 1 with a 40% annual growth for the following 2 years and then slowing to 4% growth into the foreseeable future. The probability of this occurring is estimated to be 30%. ? "Average": Year 1 operating profits are $1,100,000 and grow at 5% in perpetuity (55% probability). ? "Poor": Year 1 operating profits are $800,000 but decline by 10% each year (15% probability).

1. What is the NPV of this project?

2. If you wait until year 1 so that there would be no uncertainty about the project's outcome before investing (another firm introduces the product first), what is the project's NPV?

3. How much Three Kings would value the option to postpone the decision to invest?

4. Upon presenting your findings above to your boss, she presents the concern that waiting a year and allowing another firm to enter the market first forfeits potential gains from early branding in the new market. This would be expected to reduce first year of operating profits to 85% of those initially projected (under all cases) AND the probability of a "good" outcome drops to 20% (probability of average becomes 65%, "bad" probability stays at 15%). Should you wait to invest or not?

5. How much Vortex Inc. would value the option to postpone in this new scenario?