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FIN553 Penelope Case Group 2

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FIN553 Penelope Case Group 2
FIN553 Advanced Coporate Finance
Case Study: Penelope's Personal Pocket Phones

Group 2
Brian Erber, Jaime Carreno, Wenliang Zhang, Xue Liu

(Introduction) Background info about the project.
In order to evaluate the NPV of the first-generation phone (project) ignoring the possibility of investing in the second-generation phone (project), we projected the free cash flows (FCF) of the first-generation phone through 2001 to 2006. The total FCF was calculated as EBIT plus deprecation and subtract any capital expenditures along with change in net working capital. With risk-free rate of 10%, comparable firms’ beta of 1.2, and market premium of 4%, the appropriate discount rate for the project was 14.8% using CAPM. Sum up each discounted cash flow, the NPV of the first-generation project was - $3,370,071. Since we got a negative NPV, we recommended that Penelope shouldn’t invest in the first-generation project alone.
The option for Penelope to make the follow-on investments can be treated as a call option. Therefore, we evaluated the expected value of the second-generation project by using Black-Scholes. If Penelope wanted to justify investing in the first-generation project by investing in the second-generation project, they would need the total APV equal or greater than zero, which means the sum of NPV of the first-generation project (- $3,370,071) and value of the call option to make the follow-on investment should be equal or greater than zero. The cost of second-generation project of $100 million was equivalent to the exercise price in Black-Scholes formula; its present value in 2001 was $68,301,346 (discounted at 10% risk-free rate). The value of the second-generation project was the asset price in Black-Scholes formula. Using solver function in excel, we calculated the value of the second-generation project by changing the value of the second-generation project to set APV equal to zero (or value of call option equal to $3,370,071). The
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