(a) [8 marks] A firm needs to use a minivan for three years and has two options. It can buy a minivan now for 20,600 and sell it after three years for a price that will depend on the state of the minivan: either 11,000 or 9,000, with equal probability. Alternatively, it can lease a minivan for three years for 4,000 per year. Lease payments are made annually at the end of each year and the market interest rate is 3% and is expected to stay at that level. What should the firm do, purchase a minivan and sell it in three years, or lease a minivan for three years? Explain.

(b) A small biotechnology company has developed a new technology. It can either produce itself a new drug with this technology or sell the rights to a larger drug company. The payoffs from each of these two courses of action depend on whether the technology is ultimately approved by the regulatory body that approves all new drugs. The company needs to make an irreversible decision whether to produce itself or sell the rights before the regulator decides to approve or not. The company is risk neutral and its expected payoffs (in millions of ) are the following:

If the regulator approves (probability 0.30), the company will get 10 if it has decided to sell the rights and 50 if it has decided to produce the drug.

If the regulator does not approve (probability 0.70), the firm will get 2 if it has decided to sell the rights and 20 if it has decided to produce the drug.

(i) [7 marks] What action should the biotechnology company choose, produce the drug itself or sell the rights? Explain.

(ii) [10 marks] Suppose that before making its decision to sell the rights or produce itself, the company can conduct a test that will reveal whether the new drug will be approved. Calculate the maximum amount the company will be prepared to pay for such a test, i.e. the company's value of information.