Question
Assumptions 1. The decision to invest in the Mark II must be made after three years, in 1985. 2. The Mark II has an investment
Assumptions | ||
1. | The decision to invest in the Mark II must be made after three years, in 1985. | |
2. | The Mark II has an investment requirement of $935 million, which is taken as fixed. | |
3. | Forecasted cash inflows of the Mark II have a present value in 1985 of $842 million and $487 million (842 / 1.23 = 487) 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 42% per year. | |
5. | The annual interest rate is 12%.
| |
Interpretation | ||
The opportunity to invest in the Mark II is a three-year call option on an asset worth $487 million with an exercise price of $935 million. | ||
How does the value of the option to invest in the Mark II in 1982 change if:
a. The investment required for the Mark II is $835 million (vs. $935 million)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
b. The present value of the Mark II in 1982 is $535 million (vs. $487 million)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
c. The standard deviation of the Mark II's present value is only 27% (vs. 42%)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
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