A firm has an irreversible investment project. There is an initial investment requirement of $1600; once the project is(instantaneously) implemented, it will produce 1 unit of the output per year, and the operating cost is zero. The current output price is $P per unit, but the price will change next year to either 1.2P or 0.8P (with equal probabilities); and will remain unchanged thereafter. The appropriate discount rate is 12%. The decision rule is: invest now if P equals or exceeds P*.

(a) Compute P*.
(b) If the company has existing debt, and the new project is financed with equity, will P* be higher or lower than in part

(a) Why?

Answer rating: 100% (QA)

a P 1600112 142857 b P will be lower than in part a because the cost of equity will ... View the full answer