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Jenny Rene, the CFP of Asor Products, Inc. has just completed an
evaluation of a proposed capital expenditure for equipment that would
expand the firm's manufacturing capacity. Using the traditional NPV
methodology, she found the project unacceptable because NPV
traditional = -$1,700 < $0 Before recommending rejection of the
proposed project, she has decided to assess whether there might be
real options embedded in the firm's cash flows. Her evaluation
uncovered three options: Option 1; Abandonment; The project could
be abandoned at the end of 3 years, resulting in an addition to NPV of
$1,200. Option 2; Expansion; If the project outcomes occurred, an
opportunity to expand the firm's product offerings further would
become available at the end of 4 years. Exercise of this option is
estimated to add $ 3,000 to the projects NPV. Option 3: Delay;
Certain phases of the proposed project could be delayed if market and
competitive conditions caused the firm's forecast revenues to develop
more slowly than planned. Such a delay in implementation at that
point has a NPV of $10,000. Jenny estimated that there was a 25%
chance that the abandonment option would need to be exercised, a
30% chance that the expansion option would be exercises, and only a
10% chance that the implementation of certain phases of the project
would have to be delayed. a) use the information provided to calculate
the strategic NPV, NPV strategic , for Asor Products' proposed
equipment expenditure. b) judging on the basis of the findings in part
a, what action should jenny recommend to management with regard to
the proposed equipment expenditure? c) In general, how does this
problem demonstrate the importance of considering real options when
making capital budgeting decisions?
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