Look again at the valuation in Table of the option to invest in the Mark II project.
Question:
a. Increased uncertainty (higher standard deviation).
b. More optimistic forecast (higher expected value) of the Mark II in 1985.
c. Increase in the required investment in1985.
Transcribed Image Text:
Assumptions 1. The decision to invest in the Mark Il must be made after three years, in 1985. 2. The Mark Il investment is double the scale of the Mark I (note the expected rapid growth of the industry) Investment required is $900 million (the exercise price), which is taken as fixed. 3. Forecasted cash inflows of the Mark ll are also double those of the Mark I, with present value of $807 million in 1985 and 807/(1.2)3 $467 million in 1982. 4. The future value of the Mark Il cash flows is highly uncertain. This value evolves as a stock price does with a standard deviation of 35% per year. (Many high-technology stocks have standard deviations higher than 35%) 5. The annual interest rate is 10%. Interpretation The opportunity to invest in the Mark Il is a three-year call option on an asset worth $467 million with a $900 million exercise price. Valuation PV(exercise price) 676 Call value = [N(d) x PJ-[N(de) x PV(EX)] log[.691V606 606/23072 N(d) 3793, N(d2)1805 Call value-I-3793 × 467]-[.1805 × 676] $55.1 million
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Related Book For
Principles of Corporate Finance
ISBN: 978-0077404895
10th Edition
Authors: Richard A. Brealey, Stewart C. Myers, Franklin Allen
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