Sally Rubber Co. is looking at investing in a production facility that will require an initial investment of $500,000. The facility will have a three-year useful life, and it will not have any salvage value at the end of the project’s life. If demand is strong, the facility will be able to generate annual cash flows of $265,000, but if demand turns out to be weak, the facility will generate annual cash flows of only $125,000. Sally Rubber Co. things that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.
If the company uses a project cost of 11%, what will be the expected net present value (NPV) of this project?
Sally Rubber Co. could spend $510,000 to build the facility. Spending the additional $10,000 on the facility will allow the company to switch the products they produce in the facility after the first year of operations if demand turns out to be weak in year 1. If the company switches product lines because of low demand, it will be able to generate cash flows of $260,000 in years 2 and 3 of the project.
What is the expected NPV of this project if Sally Rubber Co. decides to invest the additional $10,000 to give themselves a flexibility option?
What will be the value of Sally Rubber Co.’s flexibility option?