A breakfast cereal maker is considering introducing a gluten-free version of its best-selling breakfast cereal. Market research provided the following information: It will cost the company $8million to acquire the facilities needed to produce the new cereal. There is 60% chance that the new cereal will be popular with consumers. If it was popular, it will generate a net cash flow of $1million per year in perpetuity, otherwise it will generate $0.4million per year in perpetuity. If the product was unpopular, the company has the option to discontinue the product and sell the facilities for $8million after 1 year. The cost of capital is 10%.

a. What type of real option is available to the cereal maker? Under what circumstances the option should be exercised? (2 Marks)

b. Should the company produce this new cereal? (4 Marks)

c. What is the value of the real option? Would the cereal maker’s decision be different if the real option was not available?(4 Marks)