Luci is the manager of a manufacturing company. She is considering whether or not to invest in a patent which allows her company to produce e-Dance. The patent costs 1 million now and it will be worthless three years from now due to the development of other new technology. The annual cost for the production is 12 million.

As the market for e-Dance is not mature at the moment, Luci does not plan to produce any e-Dance until the third year. She expects that the market condition in the third year will be one of the following situations:

• Economic Condition Very good: probability 0.3. Gross Return from production 18 million
• Economic Condition Normal: Probability 0.4. Gross Return from production 15 million
• Economic Condition Bad: Probability 0.2. Gross Return from production 13 million
• Economic Condition Very Bad: probability 0.1. Gross Return from production 11 million

The required cost of funding for Luci's company is 11%.

(i)Under what conditions will Luci choose to invest? What is the value of the patent under each economic condition?

(10 marks)

(ii)Using the concept of real option, estimate the value of the patent to Luci's company.

(6 marks)

(iii)Should Luci's company invest in the patent?

(2 marks)