Final answer:
To evaluate the benefit of the expansion option on a dividend paying project, calculate the present value of the project and compare it to the present value of the expanded project.
Step-by-step explanation:
The firm wants to evaluate the benefit of an expansion option on a dividend paying project. The present value of the project is $10m with an annual volatility of 45%. The required initial investment is $9m. The project is expected to generate annual free cash flow equal to 20% of its value. There is a 2-year option to expand operations by 25% at any time with an additional investment of $2.5m. The risk-free rate is 2%.
To evaluate the benefit of the expansion option, we can calculate the present value of the project and compare it to the present value of the expanded project. The present value is calculated by discounting the future cash flows at the risk-free rate. We can then subtract the initial investment and the present value of the expanded project to determine the benefit of the expansion option.
The student is tasked with evaluating the benefits of an expansion option for a project with given financial parameters. The question involves calculating the present discounted value (PDV) of the project's expected future cash flows, as well as considering the option to expand. Since the project is expected to generate an annual free cash flow of 20% of its value, which translates to $2 million annually ($10 million * 20%), the firm must decide whether it is beneficial to invest an additional $2.5 million for a 25% expansion after two years.
The problem requires the application of financial concepts such as the time value of money, present value calculations, volatility, and option valuation using parameters like the risk-free rate, expected cash flows, and initial investment costs. This evaluation will help determine if the expansion yields a positive net present value.