Question

DCF analysis doesn't always lead to proper capital budgeting decisions because capital budgeting projects are not passive investments like stocks and bonds. Managers can often take positive actions after the investment has been made to alter a project's cash flows. These opportunities are real options that offer the right but not the obligation to take some future action. Types of real options include abandonment, investment timing, expansion, output flexibility, and input flexibility. The existence of options can projects' expected profitability, increase their calculated NPVs, and decrease their risk. increase The abandonment option is the option to shut down a project if operating cash flows turn out to be lower than expected. To analyze the abandonment option you can draw a decision tree, which is a diagram that lays out different branches that are the result of different decisions made or the result of different economic situations. When analyzing real options you consider the project with and without the option. The option value is calculated as the difference between the expected NPVs with and without the relevant option. (If the value of the project without the option is negative and the NPV of the project with the option is positive, then the option value is simply the calculated NPV of the option.) It is the value that is not accounted for in a traditional NPV analysis and a positive option value expands the firm's opportunities.

Please help me fill in the last blank

UPDATE: This is all the information I have been given. I just need help with the last blank.

Answer 1

NPV in case of "Weight loss" smoothie is well received (40%)

=-3500000+2200000/1.11+2200000/1.11^2+2200000/1.11^3

= $1876172

NPV in case of "Weight loss" smoothie is poorly received (60%) and the company decides to continue

=-3500000+520000/1.11+520000/1.11^2+520000/1.11^3

= -$229268

NPV in case of "Weight loss" smoothie is poorly received (60%) and the company decides to abandon

=-3500000+520000/1.11+2800000/1.11

=-$509009

As the NPV on exercising the option and abandoning the project is less negative than if company decides to continue, company is better off abandoning and the NPV of abandoning is taken as the NPV in case of poor demand

So, Expected NPV = 40%*$1876172 + 60%* (-$509009) = $445063.54 or $0.45 million dollars