Reference no: EM133003558

A state-of-the-art automobile assembly plant designed to produce a new line of Harley, called the V-Rod, will cost $200 million to build. If V-Rod is successful, the new plant will generate a constant stream of revenues in the amount of $500 million per annum. However, if V-Rod is a bust the anticipated stream of revenues will be in the amount of $200 million per annum. Financial analyst's assessment reveals a 40% chance of success and a 60% chance of failure. Costs of goods are approximately 80% of revenues and are expected to be constant through the years. The level of working capital is 5% of the next year's sales revenues. The risk-adjusted cost of capital for this particular project is 20% while the opportunity cost of capital for the company is only 9%. The marginal tax rate is 40% for the company.

You may assume that this project has a twenty-year term and that the firm uses a straight-line depreciation method with a zero salvage value.

Now, suppose that the firm can pay a third party, the Silly Insurance Co., $12 million today at t=0 to insure the firm against the project's future downside risk exposure. In particular, the writer of the insurance contract agrees to purchase the plant from the company at a pre-determined price of $190 million, to be paid at t=2 (end of the year) after two full years of operations. In other words, the firm has an option to abandon the project after two years of operation.

Problem 1: Given this insurance option, should the firm undertake the investment project now?

Problem 2: Should the firm purchase this insurance contract?