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Management has gone ahead with the investment in Exhibit Table 1 , but the market is very competitive and several competitors are considering abandoning the
Management has gone ahead with the investment in Exhibit Table but the market is very competitive and several competitors are considering abandoning the market. If they do not abandon, price will remain at the current level of ton in perpetuity. It is equally likely that they will abandon, in which case the price will rise to ton As a result, price will be either or with equal probability in one year. Because of labor agreements, management must either produce at capacity or close the plant, at a cost of million. This abandonment cost rises at per year. Assume the plants abandonment decision does not influence competitors abandonment decisions, so price uncertainty is exogenous. Other facts are as in Exhibit Table
a Calculate the NPV of abandoning today as if it were a nowornever alternative.
b Calculate the NPV as of t of waiting one year before making a decision.
c Suppose price will be either or with equal probability in one year. How does this increase in price uncertainty affect option value?
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