Layers Bakeshop wants to beat Kitchen Cuisine out of business. For that owners of Layers are considering a project that will cost Layers PKR 70 million and will generate expected cash flows of PKR 30 million per year for three years.
The cost of capital for this type of project is 10 percent and the current risk- free rate is 6 percent.
After discussions with the marketing department of Layers which keeps an eye on all the branches of Layers in the country, owners learn that there is a 30 percent chance of high demand, with future cash flows of PKR 45 million per year. There is a 40 percent chance of average demand, with cash flows of PKR 30 million per year. If demand is low, cash flows will be only PKR 15 million per year.
This project has an investment timing option, since it can be delayed for a year. The cost will still be PKR 70 million at the end of the year, and the cash flows for the scenarios will still last three years. Use decision tree analysis to calculate the NPV of the project with the investment timing option.
