Reconsider General Design’s diamond film project from Table 8.6(b). Suppose that General Design now believes it also has an option to grow the project if things go well. Initial success in diamond film
semiconductors will open the door to a stage 2, follow-on investment in two years that will be five times as large as the initial stage 1. Stage 2 will be undertaken only if stage 1 is successful, and management believes the chance stage 2 will succeed, given that stage 1 has succeeded, is 90 percent. The discount rate is still 15 percent.
a. What are the cash flows for the stage 2 investment? What is the present value of the cash flows for the stage 2 investment if it succeeds? If it fails? What is the present value of the initial cost of
the stage 2 investment?
b. If General Design were to evaluate the stage 2 decision today (before learning whether stage 1 is successful), what is its NPV?
c. Assuming General Design waits to learn whether stage 1 is successful:
i. What is the NPV today of the stage 2 investment?
ii. What is total project NPV, incorporating the option to grow?
iii.What is the value of the option to grow?
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