Say that we plan to make a new computer product. We have already spent a total of = $5M. The project will require an additional investment of I =$3M at t = 0 (now). This investment must be made now, or the project cannot proceed. Also, the product will require us to acquire some intellectual property (IP) to defend ourselves from potential lawsuits from competitors.

Suppose that the cost of the IP will be 0:1S_t (in millions), where S_t is the stock price for Google (GOOG). That is, if Google becomes more successful, the intellectual property will be more expensive to buy. Although we must invest I at t = 0, we may choose to wait one year to acquire the IP and sell the product. Whether we choose to acquire the IP at t = 0 or t = 1, the product will go to market at t = 1 and will produce revenues of R = $65M with no additional costs.

Suppose the risk free rate is r = 2% (EAR). Also say that Googles current stock price is $600. Suppose also that Googles stock at t = 1 will either rise to $740 (60% chance actual probability) or fall to $580 (40% chance actual probability).

Consider the following options:

O1. Invest now (t = 0), acquire the IP now (t = 0), and produce the product at t = 1. O2. Invest now (t = 0), but wait until t = 1 and, if conditions are favorable, acquire the IP and produce the product.

Find the risk-neutral probability that GOOGs stock price at t = 1 is $580.

Find the value of a put on GOOG struck at K = $580 expiring in one year.

Compute the NPV of strategy O1.

Compute the NPV of strategy O2.

Which strategy would you recommend? Does your answer depend on how risk-averse you are? Why or why not.