Chapter 11, Problem 16SP

(Real options and capital budgeting) You have come up with a great idea for a Tex-Mex-Thai fusion restaurant. After doing a financial analysis of this venture, you estimate that the initial outlay will be $6 million. You also estimate that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $800,000 per year forever (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only $200,000 per year forever (a perpetuity) if it isn’t received well.

1. a. What is the NPV of the restaurant if the required rate of return you use to discount the project cash flows is 10 percent?
2. b. What are the real options that this analysis may be ignoring?
3. c. Explain why the project may be worthwhile, even though you have just estimated that its NPV is negative.