Reliable Machinery Inc. is considering expanding its operations in Thailand. The initial analysis of the projects yields the following results.
- The project is expected to generate $85 million in after-tax cash flows every year for the next 10 years.
- The initial investment in the project is expected to be $750 million.
- The cost of capital for the project is 12%. If the project generates much higher cash flows than anticipated, you will have the exclusive right for the next 10 years (from a manufacturing license) to expand operations into the rest of South East Asia. A current analysis suggests the following about the expansion opportunity.
- The expansion will cost $2 billion (in current dollars).
- The expansion is expected to generate $150 million in after tax cash flows each year for 15 years. There is substantial uncertainty about these cash flows and the standard deviation in the present value is 40%.
- The cost of capital for this investment is expected to be 12% as well. The riskfree rate is 6.5%.
a. Estimate the net present value of the initial investment.
b. Estimate the value of the expansion option.