Hi all, the question comes from exercises 18 from the reading 23, which it asks about the NPV with an expansion option
- The original project:
- An outlay of C$190 million at time zero.
- Cash flows of C$40 million per year for Years 1–10 if demand is “high.”
- Cash flows of C$20 million per year for Years 1–10 if demand is “low.”
- Additional cash flows with the optional expansion project:
- An outlay of C$190 million at time one.
- Cash flows of C$40 million per year for Years 2–10 if demand is “high.”
- Cash flows of C$20 million per year for Years 2–10 if demand is “low.”
- Whether demand is “high” or “low” in Years 1–10 will be revealed during the first year. The probability of “high” demand is 0.50, and the probability of “low” demand is 0.50.
- The option to make the expansion investment depends on making the initial investment. If the initial investment is not made, the option to expand does not exist.
- The required rate of return is 10 percent.
What is the NPV (C$ millions) of the optimal set of investment decisions for Society Services including the expansion option?
How the answer calculated the answer is following 1. calculate the binominal price of the project without option 2. calculate the NPV of high scenario, times 0.5, and add this value to the no option project value
Why is it calculated like this? what I would do is calculate high and low scenario and add the weighted sum, and this question itself is confusing me, whats the use of the option here?