Question

Two high-school friends are considering starting a company producing electric-powered fins. They are avid divers and would enjoy extra speed when tired or just chasing after an awesome fish. They looked at similar Kickstarter campaigns and realised that that the success rate is not impressive - just about 15% of project get funded and make money. If they are among the lucky ones, they can make as much as $10 M, but if they fail, they will probably have to walk away with zero. Full-scale production would cost them $1 M if undertaken today, and in addition, they would have to spend about $100 000 to produce a few prototypes to test for demand. They estimated a risk-appropriate discount rate to be 35%. It would take them about a year of beta-testing to figure out if there is demand for their project or not. They can delay starting full-scale production by a year, but then the costs would increase by 35%. What is the value of the option to wait one year? Risk free rate is 5%.

Answer 1

Expected Value of the company after one year = $10 million * 15% = $1.5 million

So, NPV of the project if they do not wait = -$1 million - $100000 + $1.5 million/1.35

=$11,111.11

If they wait

Expected value after one year if they succeed = -$1.35 million + $15 million/1.35 = $9,761,111.11

Expected value after one year if they fail = 0 (as the project would not be continued)

So, expected value of project after one year = $9,761,111.11*15%+0*85% = $1,464,166.67

So, NPV of project today (on waiting) = -100000+1464166.67/1.35 = $984,567.90

Value of the option to wait = $984567.90 - $11,111.11= $973456.79