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Question. A retail development project runs for 2 periods before the completed property is sold at a fair price. Its present value without flexibility is $40 million, and the initial investment is $25 million. The annual volatility of the project’s present value is expected to be 20% and its WACC is 12%.
At the end of the second period there is an option to expand, increasing the value of the development project by 30% by investing an additional $10 million.
The risk free rate is 5%.
(a) What is the project’s NPV without the option to expand?
(b) What is its ROA (real option analysis value) with the option to expand?
Given two projects, what are the decision models that you can use to make a decision as to which project you should accept? Which is the better?
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Which of the two long-term financing securities (debt or equity) would potentially maximize shareholder earnings more?
At what discount rate would you be indifferent between accepting the project and rejecting it?
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