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    Lecture 6 Explanation

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    Derek Leung
    The document summarizes an investment opportunity with an option to expand. It presents a decision tree showing that initially, the NPV is negative without considering the expansion option. However, after one year there is a 50% chance of success generating $1M annually or failure generating nothing. If successful, there is an option to double the investment, generating $2M annually. Factoring in this expansion option, the expected NPV at time 0 is positive $3.145 million.

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    Lecture 6 Explanation

    Uploaded by

    Derek Leung
    5 views2 pages
    The document summarizes an investment opportunity with an option to expand. It presents a decision tree showing that initially, the NPV is negative without considering the expansion option. However, after one year there is a 50% chance of success generating $1M annually or failure generating nothing. If successful, there is an option to double the investment, generating $2M annually. Factoring in this expansion option, the expected NPV at time 0 is positive $3.145 million.

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    The document summarizes an investment opportunity with an option to expand. It presents a decision tree showing that initially, the NPV is negative without considering the expansion option. However, after one year there is a 50% chance of success generating $1M annually or failure generating nothing. If successful, there is an option to double the investment, generating $2M annually. Factoring in this expansion option, the expected NPV at time 0 is positive $3.145 million.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOCX, PDF, TXT or read online from Scribd
    Flag for inappropriate content
    Download as docx, pdf, or txt
    5 views2 pages

    Lecture 6 Explanation

    Uploaded by

    Derek Leung
    The document summarizes an investment opportunity with an option to expand. It presents a decision tree showing that initially, the NPV is negative without considering the expansion option. However, after one year there is a 50% chance of success generating $1M annually or failure generating nothing. If successful, there is an option to double the investment, generating $2M annually. Factoring in this expansion option, the expected NPV at time 0 is positive $3.145 million.

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    Attribution Non-Commercial (BY-NC)
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    Option to expand (pg 34 in slides of Lecture 6) Consider an investment opportunity with an option to grow that requires a $10 million

    investment today. In one year you will find out whether the project is successful. The risk neutral probability that the project will generate $1 million per year in perpetuity is 50%, otherwise, the project will generate nothing. At any time we can double the size of the project on the original terms.

    The Decision Tree that is associated with this case is the following:

    In time 0, you make a decision to invest or not. Before you reach the beginning of period 1, you have already seen the results and you know if the business is going to be success or not. In the beginning of period 1, you have to make a decision to double the size or stay the same. Before considering the option to double the size, you are face with one output node. In the case of success (with probability 0.5), you will receive $1 million and in the case of failure (with probability of 0.5), you will receive nothing. Expected value of such node is therefore (0.5$1 mil) + (0.5$0) = $500,000. If you do not take into account the option to double the size, NPV is negative.

    NPVwithout option

    500,000 10,000,000 $1.667 mil 0.06

    After one year, you can double the size of your project, which mean that revenue would be $2 million. This cash, however, is received during period 2. If you decide to double the size, you will receive expected cash flow of (0.5$2 mil) + (0.5$0) = $1,000,000 in year 2. You make this decision AFTER observing the outcome of the first year. After you have decided to double the size, the NPV of the project would be

    NPVafterdoubling

    1,000,000 10,000,000 $6.667 mil 0.06

    Note that this is the value of the upper branch in period 1, with only occurs with probability 0.5. The expected value of the node, therefore, would be 6.667mil 0.5 = 3.333 mil. This value, however, is a value at time 1. If we want to calculate the value at time 0, we need to discount the value. (In fact you should discount 6.667 when calculating the expected value, i.e., (6.6670.5)/1.06)

    $6.667 Double size

    $6.667 Same Size -$1.667

    Exp. Value 0.5 6.667 = 3.333

    Value at time 0 Is 3.333/ 1.06 =3.145

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