Question

​(Real options and capital​ budgeting) McDoogals Restaurants has come up with a new​ fast-food casual restaurant combining some of the features of​ Chipotle, Panera, and Shake​ Shack, but it is not quite sure how the public will react to it. McDoogals feels that there is a 50–50 chance that consumers will like it and a 50-50 chance that they​ won't. McDoogals is considering building one of these new​ restaurants; the cash flows if it succeeds and if it fails are given​ here:

The required rate of return is 10% percent. What is the NPV of the project if it is successfully​ received? What is the NPV if it is unsuccessfully​ received? Now determine the expected NPV from taking on this project given the fact that it has a 50-50 chance of success. If the project is well received by the​ public, McDoogals expects to build 20 more of these restaurants. The cash flows from these projects will be identical to the cash flows from the successful​ outcome, with the initial outlay occurring in year 1 rather than year 0 and followed by four annual cash flows of $460,000 each. The​ one-year delay for the expansion restaurants is a result of the fact that it will take one year to gauge how the public responds to the new restaurant. If it is not well​ received, then the project will be abandoned after year 4. What is the NPV of the project assuming that 20 additional of these restaurants will be​ built?

What is the NPV of the project if it is successfully​ received? (Round to the nearest​ dollar.)

50% chance of success       50% chance of failure  
Year   Cash Flow    Year   Cash Flow
0   -$1,300,000    0   -$1,300,000
1   $460,000    1   $140,000
2   $460,000    2   $140,000
3   $460,000    3   $140,000
4   $460,000    4   $140,000

Answer 1

1: NPV if successful = 158138.11

2: NPV if unsuccessful = -856218.84

3: Expected NPV = 50%*158138.11+ 50%*-856218.84

= -349040.37

4: NPV of the additional 20 restaurants = $2,875,238.28

Total NPV of the project in case it is successful and 20 new restaurants are built  = 158138.11+ 2,875,238.28 =3,033,376.39

WORKINGS