The decision to invest in the Mark II must be made after three years, in 1985.

2. The Mark II investment is double the scale of the Mark I (note the expected rapid growth of the industry). Investment required is $940 million (the exercise price), which is taken as fixed.

3. Forecasted cash inflows of the Mark II are also double those of the Mark I, with present value of $847 million in 1985 and 847 (1)^{3raise to the power of 3} = $490 million in 1982.

4. The future value of the Mark II cash flows is highly uncertain. This value evolves as a stock price does with a standard deviation of 43% per year. (Many high-technology stocks have standard deviations higher than 43%.)

5. The annual interest rate is 9%.

Interpretation

The opportunity to invest in the Mark II is a three-year call option on an asset worth $490 million with a $940 million exercise price.

How does the value of the option to invest in the Mark II in 1982 change if:

1. The investment required for the Mark II is $840 million (vs. $940 million)?
2. The present value of the Mark II in 1982 is $540 million (vs. $490 million)?
3. The standard deviation of the Mark II's present value is only 28% (vs. 43%)?

Answer rating: 100% (QA)

To determine how the value of the option to invest in the Mark II in 1982 changes with the giv... View the full answer