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 $975 million, which is taken as fixed 3 Forecasted cash inflows of the Mark II have a present value in 1985 of $882 million and $510 million (882 1 2 3 510) 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 39 per year 5 The annual interest rate is 10 Interpretation The opportunity to invest in the Mark II is a three year call option on an asset worth $510 million with an exercise price of $975 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 $875 million (vs $975 million) (Do not round intermediate calculations Round your answer to 2 decimal places ) b The present value of the Mark II in 1982 is $575 million (vs $510 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 24 (vs 39 ) (Do not round intermediate calculations Round your answer to 2 decimal places )

The Answer is in the image, click to view ...

Answered step by step

Verified Expert Solution

Link Copied!

Question

1 Approved Answer

Posted on Aug 22, 2024

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 $975 million, which is taken as fixed.
3.	Forecasted cash inflows of the Mark II have a present value in 1985 of $882 million and $510 million (882 / 1.2³ = 510) 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 39% per year.
5.	The annual interest rate is 10%.

Interpretation
The opportunity to invest in the Mark II is a three-year call option on an asset worth $510 million with an exercise price of $975 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 $875 million (vs. $975 million)? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. The present value of the Mark II in 1982 is $575 million (vs. $510 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 24% (vs. 39%)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)