Paying off a firm's debt is comparable to _____ on the assets of the firm.
A. purchasing a put option
B. purchasing a call option
C. exercising an in-the-money put option
D. exercising an in-the-money call option
E. selling a call option
We are examining a new project. We expect to sell 8,000 units per year at $80 net cash
flow apiece for the next 15 years. In other words, the annual operating cash flow is
projected to be $80 × 8,000 = $640,000. The relevant discount rate is 16 percent, and
the initial investment required is $2,740,000. The project can be dismantled after the
first year and sold for $2,130,000. Suppose you think it is likely that expected sales will
be revised upward to 9,600 units if the first year is a success and revised downward to
3,000 units if the first year is not a success. Suppose the scale of the project can be
doubled in one year in the sense that twice as many units can be produced and sold.
Naturally, expansion would be desirable only if the project is a success. This implies
that if the project is a success, projected sales after expansion will be 19,200. Assume
that success and failure are equally likely. Note that abandonment is still an option if the
project is a failure. What is the value of the option to expand?