Your factory can stamp 150,000 CDs at a cost of $5 per CD, or 500,000 CDs at a cost of $8 per CD. If your CD has a hit song, you can sell it to retailers for $10 per CD. If it is a moderate success, you can only charge $6 per CD. If it is a complete bomb, you cannot sell it at all. There is a 1-in-10 chance that your CD will be a hit, and a 3-in-10 chance that it will be a bomb. You will not find out whether you have a hit until next year, but fortunately this will be before you have to stamp CDs. Your cost of capital is 10% per year. You only have the lease of the factory for next year. There is no production this year.

a. What is the expected selling price per CD?

b. How many CDs should you produce at the expected selling pricei.e., if you had to gear the factory for a particular production quantity today?

c. What is the value of your factory if you can decide next year?

d. What is the value of flexibility in this example?

Answer rating: 100% (QA)

To answer the given questions lets break down the problem step by step a Expected Selling Price per CD The expected selling price per CD can be calculated by considering the probabilities of different ... View the full answer