Problem:
(Growth Option) Martin Development Co. is deciding whether to proceed with Project X. The cost will be $9 million in Year 0. There is a 50% chance that X will be hugely successful and will generate annual after-tax cash flows of $6 million per year during Years 1, 2, and 3. However, there is a 50% chance that X will be less successful and will generate only $1 million per year for the 3 years. If Project X is hugely successful, it will open the door to another investment, Project Y, that will require a $10 million outlay at the end of Year 2. Project Y will then be sold to another company at a price of $20 million at the end of Year 3. Martin's WACC is 11%.
1) If the company does not consider real options, what is Project X's NPV?
2) What is X's NPV considering the growth option?
3) How valuable is the growth option?