2. Real options

Your company, SunSweets is considering purchasing 10 machines, each of which has the following expected cash flows:

Year 0 1 2 3 4

CF of single machine -550 100 200 300 400

You estimate the appropriate discount rate for the machines as 25%.

a. Would you recommend buying just one machine, if there are no options effects?

b. Your purchase manager recommends buying one machine today and thenafter seeing how the machine operatesreconsidering the purchase of the other 9 machines in 6 months. Assuming that the cash flows from the machines have a standard deviation of 30% and that the risk-free rate is 10%, value this strategy using Black-Scholes Option Pricing Model.