Q5 THE OPTION TO CONTRACT CASE STUDY Exercise 12.2, Chapter 12, HGT The XYZ rm can invest in a new DRAM chip factory for $425 million. The factory, which must be invested in today, has cash ows two years from now that depend on the state of the economy. The cash flows when the factory is running at ll] capacity are as follows: Economy at t = 1 Economy at t = 2 t = 2 Good Very Good +$ 1 billion Medium +$200m Medium +$200m Bad Very Bad $5 00m In year 1, the firm has the option of running the plant at less than ll] capacity. In this case, workers are laid off, production of memory chips is scaled down and the subsequent cash flows are half of What they would be when the plant is running at full capacity. An alternative use for the rm's funds is investment in the market portfolio. In the states that correspond to the table above, $1 invested in the market portfolio grows as follows: Assume that the risk-free rate is 5 per cent per year, compounded annually. Compute the project's present value (a) with the option to scale down and (b) without the option to scale down. Compute the difference between these two values, which is the value of the option