You have been hired to estimate the value of the start-up company Garcia, Ltd

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You have been hired to estimate the value of the start-up company Garcia, Ltd. Garcia has one product, which is expected to sell in the first year for $100. The price will grow in each of subsequent years by an amount given by a normal distribution with a mean of 5% and a standard deviation of 3% (actual price change amounts in each of subsequent years can be different and are independent from year to year). Initial annual sales will be 5000 units, expected to grow by 5% per year. The unit production and distribution cost for the product is $75 in year 1, and will grow at annual rate which is random and normally distributed with mean of 10% and a standard deviation of 3% (actual cost change amounts in each of subsequent years can be different and are independent from year to year). The valuation is based on a time horizon of 10 years. The annual profit discount rate is 10%.

Garcia wants to investigate an option to decide in year 6 whether to continue in business or to go out of business. (This is what is known as a real option, as opposed to the financial options). Specifically, they intend to exercise the option to go out of business at the end of year 6 if the year 6 profit is less than some cut-off value. If they opt to go out of business at the end of year 6, they will receive zero profit in years 7-10.

Questions:

1. Build a simulation model to estimate the expected NPV of Garcia, Ltd. without the option to go out of business. Run your simulation with 20,000 trials. Based on the simulation, what is the estimate for the expected NPV of the business? What is the 95% confidence interval for the true value of the expected NPV?
2. Consider the option of going out of business at the end of year 6, if the year 6 profit is less than some cutoff value. Build a simulation model to evaluate this option for four possible cutoff values: $0, $50,000, $100,000 and $150,000. For each cutoff value, run a 20,000-trial simulation to estimate the expected NPV of the business with the option. Out of these four alternatives, which cutoff value maximizes the expected NPV of the option? Are you 95% confident that the best cutoff value outperforms the second best cutoff value?
3. The value of the option is the difference between the expected NPV with the option and the expected NPV without the option. Based on the results of your simulations from parts a) and b), what is an estimate for the value of this option for the best cutoff from part b)?