I need an explanation for this Accounting question to help me study.
- You are the CEO of your company. The Research and Development Department of your company has made a significant progress in a new technology. You are considering a pilot program using this technology to produce a brand-new product. This pilot program will last for one year and cost Â£500 million. You believe the pilot program has a 50% chance to succeed and 50% chance to fail.
If it succeeds, you will invest Â£3000 million in Year 1 to build up a complete product line, which will generate free cash flows of Â£400 million in perpetuity beginning in Year 2.
If it fails, you can still build the product line but the expected free cash flows will only be Â£200 million in perpetuity beginning in Year 2. Alternatively, you do not build the complete product line but sell the technology for Â£300 million, i.e. giving up the product. The cost of capital is 10%.
- Please evaluate the project based on the information given above.
- In a meeting with colleagues, one manager shows the concern that it might be difficult to sell the technology if the pilot program fails. You then decide to carry out a scenario analysis for your NPV calculation in Part i, assuming that the technology is worth only Â£100 million if the pilot program fails. Please show your analysis. If you are convinced by that manager and believe this scenario will happen in future, do you still want to start the project today? Please justify your decision.
- To carry out the pilot program, you need to contact new suppliers and it is possible that the cost of the pilot program may be higher than expected. Please do a break-even analysis for your NPV calculation in Part i, in which the key parameter is the cost of the pilot program. Discuss how you should use the result of this break-even analysis in your decision making.
- You also consider a plan alternative to that in Part i. In particular, you skip the pilot program and build up the complete product line directly at a cost of Â£3000 million. Assume that with a 50% chance it will generate free cash flows of Â£400 million in perpetuity beginning in Year 1 and with a 50% chance it will generate free cash flows of Â£200 million in perpetuity beginning in Year 1. The cost of capital is 10%. Please calculate the NPV assuming the pilot program is skipped.
- You understand that the pilot program is in fact a real option in this project. Please calculate the value of this real option under the conditions in Part i.