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1. Clark Industries has come up with a new prototype for a bike and is ready to...
May 6, 2024
a Solution
a
Calculating the base case NPV: We need to calculate the expected NPV considering both scenarios of success and failure of the test marketing
- Calculate the present value (PV) of cash flows in case of success: PVsuccess=£400,0000.10=£4,000,000PV_{success} = \frac{£400,000}{0.10} = £4,000,000. - Calculate the NPV of the project if the test marketing is successful: NPVsuccess=−£3,000,000+PVsuccess−£500,000=£4,000,000−£3,500,000=£500,000NPV_{success} = -£3,000,000 + PV_{success} - £500,000 = £4,000,000 - £3,500,000 = £500,000. - Calculate the PV of cash flows in case of failure: PVfailure=£250,0000.10=£2,500,000PV_{failure} = \frac{£250,000}{0.10} = £2,500,000. - Calculate the NPV of the project if the test marketing is not successful: NPVfailure=−£3,000,000+PVfailure−£500,000=£2,500,000−£3,500,000=−£1,000,000NPV_{failure} = -£3,000,000 + PV_{failure} - £500,000 = £2,500,000 - £3,500,000 = -£1,000,000. - Calculate the expected NPV: ENPV=0.50×NPVsuccess+0.50×NPVfailure=0.50×£500,000+0.50×(−£1,000,000)=−£250,000ENPV = 0.50 \times NPV_{success} + 0.50 \times NPV_{failure} = 0.50 \times £500,000 + 0.50 \times (-£1,000,000) = -£250,000.
a Answer
The base case NPV of the project is -£250,000.
Key Concept
Expected Net Present Value (ENPV)
Explanation
ENPV is calculated by taking the probability-weighted average of the NPVs from different scenarios.
b Solution
b
Calculating the value of the option to sell: We need to determine the NPV of selling the project in year one if it is unsuccessful
- Calculate the present value of the option to sell: PVsell=£300,000(1+0.10)=£272,727.27PV_{sell} = \frac{£300,000}{(1 + 0.10)} = £272,727.27. - Since the option to sell is only valuable if the project is unsuccessful, we take the probability of failure into account: Valueoption=0.50×PVsell=0.50×£272,727.27=£136,363.64Value_{option} = 0.50 \times PV_{sell} = 0.50 \times £272,727.27 = £136,363.64.
b Answer
The value of the option to sell if Clark Industries decides to sell the project in year one, assuming it becomes unsuccessful, is £136,363.64.
Key Concept
Real Option Valuation
Explanation
The value of the option to sell is the present value of the salvage price, adjusted for the probability of the scenario where the option becomes relevant.
c Solution
c
Calculating the NPV without the option to sell: If Clark Industries cannot sell the project, they can only abandon it if unsuccessful
- Since the project can be abandoned if unsuccessful, the negative NPV in the failure scenario is not realized, and the NPV calculation only considers the success scenario: NPVno_sell=0.50×NPVsuccess=0.50×£500,000=£250,000NPV_{no\_sell} = 0.50 \times NPV_{success} = 0.50 \times £500,000 = £250,000.
c Answer
The NPV, assuming Clark Industries does not have the ability to sell the project for £300,000 in one year but can abandon if unsuccessful, is £250,000.
Key Concept
Abandonment Option
Explanation
The abandonment option allows a firm to avoid realizing negative NPV in unfavorable scenarios, thus the expected NPV only includes the positive outcome.
d Solution
d
Utilizing real options in management: Managers can take advantage of real options by incorporating flexibility into investment decisions
- Identify real options within projects, such as the option to expand, abandon, or delay. - Evaluate the value of these options using techniques like decision tree analysis or option pricing models. - Incorporate the value of real options into strategic decision-making to optimize project outcomes.
d Answer
Managers can take advantage of real options by identifying them within projects, evaluating their value, and incorporating this value into strategic decision-making to improve project outcomes.
Key Concept
Real Options in Strategic Management
Explanation
Real options provide managerial flexibility to adapt to changing circumstances, which can add value to projects beyond the static NPV calculation.
1 Solution
a
Calculation of Ms. Jordan's cash flow under the current all-equity structure: Given that the EBIT is £16,000 and the firm has a 100% dividend payout rate with no taxes, the entire EBIT is distributed to shareholders. With 2,000 shares outstanding, each share gets an equal part of the EBIT
b
Ms. Jordan's cash flow under the current structure: Ms. Jordan owns 100 shares, so her cash flow is 100 times the dividend per share
c
Calculation of Ms. Jordan's cash flow under the proposed capital structure with 40% debt: The firm will pay interest on the new debt before distributing dividends. The total debt will be 40% of the firm's total value
d
Ms. Jordan's cash flow under the proposed structure: After paying interest, the remaining EBIT is distributed as dividends. Ms. Jordan still owns 100 shares, so her cash flow is 100 times the new dividend per share
1 Answer
a. Current cash flow for Ms. Jordan = £(16,000 / 2,000 shares) * 100 shares = £800 b. Proposed cash flow for Ms. Jordan = £[(16,000 - (40% of £140,000 * 8%)) / 2,000 shares] * 100 shares = £760
Key Concept
Shareholder Cash Flow
Explanation
The cash flow to a shareholder is the dividend received per share multiplied by the number of shares owned. Under a 100% dividend payout rate, the entire EBIT is distributed to shareholders in the all-equity structure, while under the proposed structure with debt, interest is paid first, reducing the dividends available for shareholders.
2 Solution
a
Understanding homemade leverage: Homemade leverage refers to the process by which investors adjust their personal leverage to replicate the effects of corporate leverage
b
Ms. Jordan's strategy to recreate the original all-equity structure: She can borrow money personally, using her shares as collateral, at the same interest rate the firm would pay on its debt
c
Calculation of the amount Ms. Jordan needs to borrow: She needs to borrow an amount that represents the same proportion of debt to equity as the firm's proposed capital structure
d
Implementation of homemade leverage: Ms. Jordan will use the borrowed funds to invest in more shares of QPR Ltd or another investment with similar risk, thus adjusting her personal cash flows to match those under the original all-equity structure
2 Answer
a. Ms. Jordan can borrow £(40% of £70 * 100 shares) = £2,800 at 8% interest. b. She will pay £2,800 * 8% = £224 in interest per year. c. Her dividends will increase by the dividends on the additional shares purchased with the borrowed funds, less the interest paid on the loan.
Key Concept
Homemade Leverage
Explanation
Homemade leverage allows investors to adjust their personal cash flows to mimic the effects of corporate capital structure decisions. By borrowing personally, investors can recreate the cash flows they would receive under different corporate leverage scenarios.
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