17. Firquell Corporation, whose required rate of return is 8%, is considering entering into a 10-year contract with a supplier, who will supply direct materials for $10 less than current market price as long as market prices stay above $100. If market prices drop below $100, the savings will drop to $5 less than market price. Firquell manufactures 200,000 units per year. Another supplier is willing to provide materials for $8 less than current market price regardless of market conditions, but Firquell must pay a cancellation fee of $1,500,000 to get out of the contract.

Market prices are expected to remain constant for the time being, but because of expected improvements in technology, there is a 60% chance that it will drop to $90 after approximately 2 years.

a. Calculate the net present value of the contract using the expected value of its savings relative to market value, without considering choices available to management.

b. Calculate the value of the contract using real options analysis.

c. Calculate the value of the real options associated with the contract.