Principles of Managerial Finance

end of which each plan would be liquidated. The relevant cash flows associated

with each plan are summarized in the accompanying table.

The firm has determined the risk-adjusted discount rate (RADR) applicable to

each plan.

Further analysis of the two plans has disclosed that each has a real option

embedded within its cash flows.

Plan X Real Option—At the end of 3 years the firm could abandon this plan

and then install the automatic equipment, which would then have a proven

track record. This abandonment optionis expected to add $100,000 of NPV

and has a 25% chance of being exercised.

Plan Y Real Option—Because plan Y does not require current expansion of

the plant, it creates an improved opportunity for future plant expansion. This

option allows the firm to grow its business into related areas more easily if

business and economic conditions continue to improve. This expansion

optionis estimated to be worth $500,000 of NPV and has a 20% chance of

being exercised.

Required

a. Assuming that the two plans have the same risk as the firm, use the following

capital budgeting techniques and the firm’s cost of capital to evaluate their

acceptability and relative ranking.

(1) Net present value (NPV).

(2) Internal rate of return (IRR).

b. Recognizing the differences in plan risk, use the NPV method, the risk-

adjusted discount rates (RADRs), and the data given earlier to evaluate the

acceptability and relative ranking of the two plans.

Risk-adjusted

Plan discount rate (RADR)

X 13%

Y 15%

Plan X Plan Y

Initial investment (CF 0 ) $2,700,000 $2,100,000

Year (t) Cash inflows (CFt)

1 $ 470,000 $ 380,000

2 610,000 700,000

3 950,000 800,000

4 970,000 600,000

5 1,500,000 1,200,000

462 PART 3 Long-Term Investment Decisions