HTG company's research scientists can begin an exciting new project at a cost of $10m now, after which there's a: 70% chance that cash flows will be $1m per year forever, starting in 5 years (t=5). This is the State A of the world. 20% chance that cash flows will be $3m per year forever, starting in 5

HTG company's research scientists can begin an exciting new project at a cost of $10m now, after which there's a: 

• 70% chance that cash flows will be $1m per year forever, starting in 5 years (t=5). This is the State A of the world.

 • 20% chance that cash flows will be $3m per year forever, starting in 5 years (t=5). This is the State B of the world. 

• 10% chance of a major breakthrough in which case the cash flows will be $20m per year forever starting in 5 years (t=5), or the project can be expanded by investing another $10m (at t=5) which is expected to give cash flows of $60m per year forever, starting at year 9 (t=9). This is the C state of the world. The firm's cost of capital is 10% pa. 

What's the present value (at t=0) of the option to expand in year 5?

Expert Answer

Cash Flow Year 5 1 5 3 5 20 5 -10 9 60 Probability 0.7 0.2 View the full answer