Maize's sales have been increasing, there seems to be a chance that demand for Maize's products will take off soon. Last year's sales generated net cash flows after all costs and taxes of $5 million. The consultants predict that sales will probably be at a level that will produce net cash flows of $6 million per year for the next three years, but they also see a 20% probability that sales could be high enough to generate net cash inflows of $8 million per year. Meeting such an increase in demand presents a problem because of the advance contracting requirements for the new capacity. Unless Maize arranges for extra facilities now, there's a 70% chance that the capacity won't be available if the increased demand materializes. An option arrangement is available with one of the large brewers under which it will hold capacity for Maize until the last minute for an immediate, nonrefundable payment of $1 million. Maize's cost of capital is 11.5%.
Draw a decision tree showing Maize's cash flows for the next 3 years without the option.
Calculate the expected NPV of operating cash flows without the option.
Draw a decision tree showing Maize's cash flows for the next 3 years with the capacity option.
What is the capacity option's value?
Should it be purchased? Why or why not?
Does the capacity option change your opinion if it should be purchased? Why or why not?