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Question 396  real option, option

Your firm's research scientists can begin an exciting new project at a cost of $10m now, after which there’s a:

  • 70% chance that cash flows will be $1m per year forever, starting in 5 years (t=5). This is the A state of the world.
  • 20% chance that cash flows will be $3m per year forever, starting in 5 years (t=5). This is the B state of the world.
  • 10% chance of a major break through in which case the cash flows will be $20m per year forever starting in 5 years (t=5), or the project can be expanded by investing another $10m (at t=5) which is expected to give cash flows of $60m per year forever, starting at year 9 (t=9). This is the C state of the world.

The firm's cost of capital is 10% pa.

What's the present value (at t=0) of the option to expand in year 5?




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