Penelope’s Personal Pocket Phones
This case is about Penelope Phillips. She is willing to start a company that would be based on next-generation wireless phone cells. She became inclined towards this business because of her experience in the electrical engineering field and the fact that about fifteen patens were held by her. The market that she was willing to invest in is quite competitive and requires a lot of research work to keep up to date with the newest technologies and generations of phones. The regular research work itself also requires a good amount of capital. However, Penelope is exploring every aspect of this market to determine whether or not the investment should be done for her to enter such a competitive market. (Gompers, 1999)
In order to determine whether or not she invests in the market, Penelope requires to determine the value of the underlying investment opportunity. Here we will be using two different valuation approaches to identify the worth of this investment opportunity. These approaches are the DCF approach and the Real option Approach. By using the DCF approach we would be able to determine the value of the company, whereas by using the real options approach we would be able to determine the value and the project so that she could decide that her sale of equipment after 2 years from now, in order to invest in the company would be worth it not.
First, we would be determining the company’s value from the year 2001 to 2006. To do so we will use the DCF approach which is a very common valuation approach. The DCF analysis will give us the NPV and IRR of the underlying investment opportunity.
For the DCF analysis, we have first identified the WACC of the company by using the information that was provided in the case. For the calculation of WACC, we first calculated the cost of equity by using the CAPM approach. For that, we used a risk-free rate of 10% (given), beta at 1.2(given), and a risk premium of 4% (assumed). Using the calculated value of cost of equity we determined the WACC of the company to be at 14.8%. We used this value to discount the free cash flows (FCF) of the company. The FCF of the company was calculated by adding depreciation to EBIT and then subtracting the capital expenditure values along with the values for change in net working capital of the company each year. Lastly, we added all the discounted free cash flows of the company to get the net present value of the project. Following the overall approach, the NPV of the company is calculated to be negative $3,053,000.56. The IRR of the company was calculated to be negative 2%. The negative values for the IRR and NPV suggest that Penelope should not invest in the company as it would not bring any profit to her.
Note: Refer to Exhibits 1 and 2 for calculations.
Real Options Approach
Penelope has the equipment that could be sold in the year 2 from now for $4 million. According to her friend, she could use that money from the sale of equipment to invest in the project. For that, she requires to determine the value of the project after two years from now. But according to her research, the cash flow that she is expecting from the investment could be increased or decreased by 64.9% or 39.3% respectively. In this scenario, she could determine the value of the project after two years from now along with the possibility of an increase or decrease in cash flow by using the Real options analysis.
For the calculations in this approach, we first determined the sum of all discounted future cash flows. Its value was calculated as $6494.520. Then we calculated the size of the up move and the size of the down move by using the increasing and decreasing rates. The up value was calculated as $10709.46 and the down value as $3942.172. Implying that with the increase, the value of the project after 2 years would be $1998.65, whereas with the decrease it would be negative $4768.63. The possibilities of the investment were determined as 0.47 for an increase in value and 0.53 for a decrease in value. BY multiplying the probabilities with the up and the down values and then adding these calculated figures, we were able to determine the value of the project after two years with the factor of increase and decrease as$945.622. In the calculation of this figure, the negative value of the investment after 2 years was not considered because in the case of negative estimations there would be no investment. The PV of net cash flows was determined by adding the $945.63 value of the project to the discounted cash flow from the sale of equipment i.e. $3035 and subtracting them from discounted capital investment for the project i.e. negative $8710.8. Finally, with the calculated figures of these discounted cash flows from the project, we determined the discounted project value with the sale of equipment to be as negative $4730.06.
Note: Refer to Exhibits3 and 4 for calculations.
Conclusion and Recommendation
Based on the analysis it is determined that both the IRR and NPV of the company are negative. The discounted value of the project after the sale of equipment along with the factor of increase and decrease of cash flows each year was also calculated only to give the negative value. Hence based on the all calculated negative figures, it is recommended to Penelope that she should not invest in the company as it would only bring a loss of capital to her….
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