1. An investment project has present value that increases by 20% or decreases by 10% each year. The current present value is 100. There are no cash flows from the investment project in the next 2 years. Suppose you can make an investment of 100 at any time over the next 2 years to acquire the present value. The risk free rate is 3%.

(a) What is the value of the option to invest?

(b) Suppose the project is riskier than you had originally thought, and that the present value increases by 30% or decreases by 20% each year. What is the value of the option to invest now?

(c) Explain the intuition for the difference between (a) and (b).

2. Answer the following questions.

(a) Explain the efficient market hypothesis, and what implications this hypothesis has for corporate managers.

(b) Explain the net present value criterion and the internal rate of return criterion for investment decisions. Also explain in what way they can lead to conflicting conclusions.

(c) Explain the payback method for making investment decisions. Also explain why this method is not appropriate for making investment decisions.