Quality Wireless is considering making an investment in China. While it knows that the investment will cost $1 billion and generate only $800 million in cash flows (in present value terms), the proponents of expansion are arguing that the potential market is huge and that Quality should go ahead with its investment.
a. Under what conditions will the expansion potential have option value?
b. Assume now that there is an option value to expansion that exactly offsets the negative net present value on the initial investment. If the cost of the subsequent expansion in 5 years is $2.5 billion, what is your current estimate of the present value of the cash flows from expansion? (You can assume that the standard deviation in the present value of the cashflows is 25% and that the riskless rate is 6%.)