Assume that the company can purchase an option for this investment. The option allows the company to abandon the investment after 1 year and sell the equipment for 50% of its original cost (i.e., 0.5 x $10,000); OR, it can expand, which will result in twice the cash flow value (i.e., 2 x $12,000, or 2 x $7000). To expand, the company will have to make an additional capital investment of $4500. What should the price of this option be (i.e., if the company has to pay up-front in year 0 for an “option” that allows the flexibility described, what should it pay)? The riskless rate is 2% per year.

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The price of the option should be 1839 COMPUTATIONS Option 1 Abandon the investment after 1 year a... View the full answer