Ashley sat in her laboratory at the university of north and tried to determine whether she should start a company focussed on the next generation of wireless phone technology. Her work in electrical engineering and the 15 patents she held told her that she could enter the market with a new generation of phones. The problem was, however, that the market was quite competitive and she knew that it would therefore be difficult to succeed. Ashley understood that getting into the market today might lead to much bigger opportunities in the future.
Ashley looked at her projections. In order to get the first generation to market she would have to invest $10 million in the first year. The cash flow forecasts in Exhibit 1 show what she expected to earn on the first product. Comparable firms in the industry had unlevered betas of around 1.2 and annual standard deviation of returns of 50%, so she set out to see if the investment was worth the time and energy. The 10-year Treasury bond was yielding 10.0% at the time
Ashley also knew that by starting the company today, she would have the opportunity to invest in the subsequent generation of the phones. Given the expectations about future costs, this opportunity would take $100 million to bring to market. She estimated, however, that she would have to make the investment four years from now when the entire $100 million would have to be invested. She wondered how big the current expected value on the second-generation phone would have to be in order to justify investing in the proposed project. She set about trying to calculate that value.
Thirty minutes into her calculations, Jay Thomas called to tell her that she would be able to start the project using equipment that could easily be sold for $4 million in year two if demand was not high for her phones. By year two, she could be reasonably confident of what the value of her first generation of phones would be; that is, she assumed that the value would be known with certainty at that time. If that were the case, Ashley wondered what the value of the first project would be. She decided to ignore the second-generation phones for a while and focus on the new problem. Did the possibility of selling the equipment at the end of year two make the first project worth it even if there were no follow-on project? If she modeled the annual change in value, Ashley figured that the expected value of cash flows from the first-generation phones would either increase by 64.9% or decrease by 39.3% each year. She wondered how to proceed with her analysis.
Assume that the market risk premium is 6%. Please use the Black-Scholes-Merton and Binomial models for your computation. Note: All the figures found in Exhibit 1 within the case are in thousands.
Please use Excel, complete with formulae, to generate your answers. If you need to type in short textual detail, please do so in your Excel sheet. Case reports will be evaluated on both the quality of the analysis and the effectiveness of the communication. Please communicate your arguments in a persuasive, cogent, and jargon-free manner. Constructive use of tables and graphs is encouraged; extensive sensitivity analysis or Monte Carlo simulation without a concrete interpretation is not encouraged. The reports should not exceed five double-spaced, typewritten pages, excluding tables or graphs. Please use a 12-point font and 1-inch margins on each side