The decision to invest in the Mark II must be made after three years, in 1985. 2.
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Question:
The decision to invest in the Mark II must be made after three years, in 1985. |
2. The Mark II investment is double the scale of the Mark I (note the expected rapid growth of the industry). Investment required is $940 million (the exercise price), which is taken as fixed. |
3. Forecasted cash inflows of the Mark II are also double those of the Mark I, with present value of $847 million in 1985 and 847 (1)3raise to the power of 3 = $490 million in 1982. |
4. The future value of the Mark II cash flows is highly uncertain. This value evolves as a stock price does with a standard deviation of 43% per year. (Many high-technology stocks have standard deviations higher than 43%.) |
5. The annual interest rate is 9%. |
Interpretation |
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The opportunity to invest in the Mark II is a three-year call option on an asset worth $490 million with a $940 million exercise price. |
How does the value of the option to invest in the Mark II in 1982 change if:
- The investment required for the Mark II is $840 million (vs. $940 million)?
- The present value of the Mark II in 1982 is $540 million (vs. $490 million)?
- The standard deviation of the Mark II's present value is only 28% (vs. 43%)?
Related Book For
Principles of Corporate Finance
ISBN: 978-0077404895
10th Edition
Authors: Richard A. Brealey, Stewart C. Myers, Franklin Allen
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