256 Corporate Finance
If plant construction is delayed, construction costs are expected to increase 10 percent per annum. Sales are expected to
increase to 11 percent per annum from 5 percent, one year after the investment is made. Due to increased efficiency cost of
goods sold will decrease from 65 percent to 60 percent of the sales. S, G & A, depreciation and capital investment remain
the same. Capital expenditure required to maintain only the plant will equal depreciation expense of the plant. The new
plant has the same risk complexion as the firm itself.
The managers of the company have decided to wait for three years before building the plant. In other words, the managers
have a three-year real option starting three years from now. The standard deviation of project returns and risk-free rate are
45 percent and 5 percent respectively.- Estimate the value of the target company’s equity without the new plant.
- Estimate the value of the real option assuming managers defer the construction of the plant for 3, 4, and 5 years.