16.1 A proposed brewery in the Central European country of Dubiety will produce a beer—the “Dubi Dubbel”—for Grolsch N.V. of the Netherlands. A number of other European brewers have announced plans to produce and sell beer in the Dubi market. If too many breweries open, beer prices will fall. If some of these investment plans do not materialize, prices are likely to rise. The price of beer is determined exogenously and will be known with certainty in one year. Grolsch management must decide whether to begin production today or in one year. The following facts apply: Initial investment Price of beer in 1 year Variable production cost Fixed production cost Expected production Discount rate Io = D200,000,000; rises by 10% each year P1 = D25 or D75 with equal probability VC = D10 per bottle FC = D10,000,000 per year Q = 1,000,000 bottles per year forever i= 10%
a. Draw a decision tree that depicts Grolsch’s investment decision. b. Calculate the NPV of investing as if it were a now-or-never alternative. c. Calculate the NPV (at t = 0) of waiting one year before deciding. d. Calculate the NPV of investing today, including all opportunity costs. e. Should Grolsch invest today or wait one year before making a decision? 16.6 Grolsch management has gone ahead with the investment in Problem 16.1. The market has grown increasingly competitive, and nearly all of the brew- ery investments in Central Europe are losing money. To make matters worse, variable production costs of D20/bottle are higher than expected. According to local laws, employees cannot be laid off so long as the brewery is open, and Grolsch must either produce at capacity or close the brewery. A competi- tor is considering exiting the market. If this brewer does not abandon, price will remain D15/bottle. If the brewer abandons, price will rise to D35/bottle. Assume Grolsch’s abandonment decision does not influence the competitor’s decision, so price uncertainty is exogenous. The following facts apply to the abandonment decision: Cost of abandoning Current price of beer Price of beer in 1 year Variable production cost Fixed production costs Expected production Discount rate 10 = D10,000,000; rises by 10% each year Po =D15 per bottle in perpetuity P, = D15 or D35 with equal probability VC = D20 per bottle FC = D10,000,000 per year Q = 1,000,000 bottles per year forever i = 10% Note that the cash flows of this abandonment option are similar to those of the investment option. Grolsch management can pay an exercise price today to avoid future losses. But avoiding future losses is the same thing as receiving a net cash inflow-just as in the investment option. a. Draw a decision tree that depicts Grolsch’s investment decision. b. Calculate the NPV of abandoning as if it were a now-or-never alternative. c. Calculate the NPV of waiting one year before making a decision. d. Calculate the NPV of abandoning today, including all opportunity costs. e. Should Grolsch abandon this losing venture today?
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