HW: Real Options Examples: 1. Nike has developed a prototype for a Nike-branded baseball that the firm plans to market to Major League baseball, college baseball, and high school baseball. They hope...

HW: Real Options Examples:
1. Nike has developed a prototype for a Nike-
anded baseball that the firm plans to market to Major League baseball, college baseball, and high school baseball. They hope that the baseball is accepted as the new standard for most leagues, but the ball’s rate of market adoption is uncertain. In order to have the ball ready in 1 year, Nike would have to invest $50 million to set up contractual relationships with third-party contract manufacturers in China. The ball’s average total cost would be $0.50 and the selling price would be $1.50. Based on market surveys, Nike believes that there is a 25% chance of a high rate of adoption, in which 100 million balls will be sold annually forever, and a 75% chance of a low rate of adoption, in which 10 million balls will be sold annually forever. The adoption rate will be determined in one year when the first orders for the balls come in. The annual fixed costs associated with the project would be $30 million per year. Ignore tax effects and assume that Nike’s cost of capital is at 10% and the risk-free rate is 5%.
[A] What is the NPV of the project based on the project’s expected future cash flows? Based on this measure, should Nike accept the project?
[B] What is the embedded option in this project? Is the project worthwhile when considering the option?
 
 
 
2. Your firm recently purchased a hotel which is in poor condition, and you must decide between:
· [1]  A less-expensive refu
ishing, in which carpets would be replaced and low-cost fixtures would be installed, and 

· [2]  A more-expensive refu
ishing, in which ma
le floors would be installed along with high-quality fixtures. 

Option 1 would cost $6 million today and produce $2 million per year in free cash flow for 5 years, at which time a new refu
ishing would be required. Option 2 would cost $10 million today and produce $2 million per year in free cash flow for 10 years, at which time a new refu
ishing would be required. Assume that the cost of capital is fixed at 10%.
· [A]  What is the NPV of each option? Why does NPV not allow you to make the co
ect decision in this case? 

· [B]  Based on the Equivalent Annual Benefit of both options, which should be chosen? 

· [C]  Assume that in five years, a less-expensive refu
ishing is equally likely to cost either $6 million or $8 million, and last five more years generating $2 million per year. Now 
which option should be chosen? 

 
 
3. Fox Searchlight Pictures recently purchased a script for a new movie about a poker player. The movie would cost $30 million to produce. Given the growing popularity of the game, the producer believes it may be better to delay the start of production. The studio estimates that there is a 25% chance that the popularity of poker will increase in one year, and the movie would be expected to generate $40 million in the first year. Otherwise, the popularity of poker will be the same in one year and the movie would be expected to generate $20 million in the first year. In either case, the movie is expected to generate $5 million in the second year and decline by 5% per year forever. The cost of capital is fixed at 15% and the risk-free rate is 5%.
· [A] What is the NPV of the project based on the project’s expected future cash flows?
[B] What is the embedded option in this project? Is the project worthwhile when
· considering the option?
· [C] What should they do?